Coverdell education savings accounts (ESAs) are tax-advantaged accounts that allow taxpayers to save money for education. The earnings are tax-free if used for qualified education expenses. ESAs can be used to pay for education expenses at every level of education — from kindergarten to graduate school — if the education is provided by eligible education institutions.
Coverdell ESAs function much like Roth IRAs:
Contributions to Coverdell ESAs aren’t deductible and aren’t reported on your tax return.
Qualified distributions are tax-free.
There are also a couple of differences:
You open a Coverdell ESA for the benefit of another person (the beneficiary), usually your child. However, the beneficiary doesn’t have to be your child or even a relative.
Generally, the beneficiary must be under age 18 at the time of the contribution. However, the age limit is waived for certain special-needs beneficiaries. This includes individuals who, because of learning disabilities or certain physical, mental, or emotional conditions, require additional time to complete their education.
Here are the rules for contributing to an education savings account:
You can contribute to as many Coverdell ESAs as you want.
Contributions are limited to $2,000 per child, regardless of how many people contribute.
The $2,000 contribution limit is an overall limit on contributions per child. However, the amount that you can contribute is reduced if your modified AGI exceeds $95,000 on a single return ($190,000 if filing a joint return).
You must make your contribution by the time your tax return is due (usually April 15).
You can contribute to both an education savings account and a qualified state tuition plan for the same child in the same year.
You can roll over money from one ESA into another family member’s ESA. You might want to do this if a child graduates or reaches age 30, and there’s still money left in the account.
When a beneficiary reaches age 30 or dies, any assets remaining in the ESA must be withdrawn or rolled over to another qualified beneficiary within 30 days. This doesn’t apply to special-needs beneficiaries, however.
You can claim an education tax credit (if you qualify) in the same year that you make a withdrawal from an ESA.
Example: You’re a single taxpayer with a modified AGI of $80,000. You have 3 grandchildren, and you want to set up ESAs for each of them. In addition, the other grandparents of 2 of your grandchildren have already contributed $750 to each of their ESAs. Because of the $2,000 limit, you can contribute only $1,250 for these grandchildren. For the third grandchild, though, you can contribute the full $2,000.
For ESA purposes, an eligible educational institution is defined as:
Any accredited public or private college, university, vocational school, or other postsecondary educational institution eligible to participate in U.S. Department of Education Federal Student Aid programs.
Any public, private, or religious school, as determined under state law, that provides elementary or secondary education (kindergarten through grade 12). In addition, certain foreign institutions participate in the U.S. Department of Education’s Federal Student Aid programs. A list of these foreign schools can be found on the department’s Web site at www.fafsa.ed.gov.
For ESA purposes, the definition of “qualified education expenses” depends on whether the expenses are for elementary or postsecondary education.
If the distribution is for a postsecondary school, the following expenses qualify for the deduction:
Tuition, fees, books, supplies, and equipment required for enrollment or attendance
Special-needs services for a special-needs child
Room and board incurred by a student enrolled for at least one-half the full-time academic workload
Contributions to the beneficiary’s qualified state tuition program
If the distribution is for an elementary or secondary school, the following expenses qualify for the deduction:
Tuition, fees, books, supplies, equipment, and academic tutoring
Special-needs services for a special-needs child
Room, board, uniforms, transportation, and supplementary items and services (including extended day programs), if they’re required or provided in connection with attendance or enrollment at the school
The purchase of computer technology, equipment, or Internet access and related services, if it’s to be used by the child and the child’s family during any of the years the child is in elementary or secondary school. However, this doesn’t include computer software designed for sports, games, or hobbies, unless it’s predominantly educational in nature.
The amount of qualified expenses that you can use the ESA to pay for must be reduced by the amount of any nontaxable education benefits that the child receives, such as scholarships or Pell grants.
Example: Mary received a $1,000 tax-free scholarship and is also eligible for a $2,500 Pell grant. Her total expenses are $10,500. Because Mary receives nontaxable education benefits, she can only use $7,000 from her ESA to pay for qualified expenses:
$10,500 (Total expenses) – $3,500 (Scholarship and Pell grant) = $7,000
For more information, see Publication 970: Tax Benefits for Education.