These special accounts were originally called Education IRAs (as in individual retirement accounts), which was confusing, because they have nothing to do with retirement. To clear away the confusion, Congress came up with a new moniker: Coverdell Education Savings Accounts (in memory of the U.S. Senator who advocated for their creation). Two other important things happened when the name changed. The annual contribution limit was quadrupled—from $500 to $2,000. And, instead of being limited to paying college bills, ESA withdrawals are tax-free as long as the money is used to pay any schooling bills — from kindergarten through graduate school.
The $2,000 limit is the most that can be set aside for any child during the year, not a limit on individual contributors, but how much anyone can contribute (toward that $2,000 limit) is controlled by the contributor's modified adjusted gross income. For 2006, the right to contribute to an ESA gradually disappears as modified AGI rises from $95,000 to $110,000 on a single return and from $190,000 to $220,000 on a joint return. Our ESA Contribution Worksheet will show you how the phase-out works.
Any number of education savings account can be set up for the same child, but the maximum amount that may be contributed in a given year for any individual is $2,000.
Contributions to an education savings account are not deductible, but earnings in the account grow tax-free.
Withdrawals from an education savings account for a child's qualified educational expenses are tax-free. Spending that qualifies for tax-free treatment includes costs from kindergarten through grad school count — at either public or private schools — and not only costs for tuition and books. Congress specifically said tax-free withdrawals can be made to pay for a computer and educational software, for example. Withdrawals for non-qualifying purposes are taxed and hit with a 10% penalty; to the extent they represent earnings.
In the past, if a contribution was made for a child to a qualified state tuition program, no contribution could be made during the same year to an education savings account for that same child. That restriction no longer applies.
In the past, you could not claim a Hope credit or lifetime learning credit for a student's expenses in the same year that money is withdrawn tax-free from the education savings account. That restriction has also disappeared.
Rollovers from an ESA to another ESA of someone in the same family are permitted. So, if the child for whom the ESA was established decides not to go to college, the money can be used tax-free for another family member. See IRS Publication 970, Tax Benefits for Higher Education for more details.