What is a Coverdell ESA?

The Coverdell Educational Savings Account (ESA) is a tool used to finance education. Often, a parent will establish a Coverdell ESA for a child who will incur expenses, such as tuition, from K-12 or college education. Only certain education expenses qualify for financing through a Coverdell ESA. The distributions from an ESA are tax-free, to the extent that they are used to pay qualified expenses.

In 2002, the Coverdell ESA was established in its current form. Before then, it was not an attractive college savings vehicle. The contribution limit, formerly $500 U.S. Dollars (USD) per year was raised to $2,000 USD per year. The contributions to a Coverdell ESA are not tax-deductible, but are tax-advantaged in two ways: the account grows tax-deferred, and normal distributions are not taxable. Contributions can be made to an ESA until the beneficiary -- the child -- reaches age 18.

Aside from tax advantages, there is an additional benefit, in that the account owner has complete discretion as to how to invest the funds. Despite the advantages, there are certain drawbacks that one should consider before establishing a Coverdell ESA. For example, the contribution limit of $2,000 USD is still relatively low, and maintenance fees are charged by the financial institutions which hold the accounts. Even a low maintenance fee could significantly affect overall return on investment.

When a Coverdell ESA is established, the child is named as the beneficiary, which in this case means that the money is distributed to the child eventually, even if not used for education. This gives the parents a smaller measure of control over the funds than can be had with some other educational savings plans. The account also must be fully withdrawn by the time the beneficiary reaches 30 years of age, or the account will be subject to penalties.

Certain restrictions also exist, regarding who may establish a Coverdell ESA. For married taxpayers, the income limit is $220,000 USD; for single taxpayers, it is $110,000 USD. In other words, if the parents’ income exceeds those levels, they are excluded from establishing an ESA for their child. However, in this case the child himself could contribute to the account, with money gifted to him by his parents first. The $2,000 USD limit is stricter, however. It means that the account itself may only receive that much per year, regardless of the number of contributors.

An ESA can be established at any financial institution that can hold an Individual Retirement Account (IRA). Other savings options beside the Coverdell ESA exist for educational expenses. One example is the 529 plan, where contribution limits are higher, and additional benefits also apply. Many people hold 529 plan accounts simultaneously with an ESA, in order to maximize savings and tax benefits.