Coverdell ESA (Education IRA)

An education IRA is a savings plan that allows parents to save for the education of their children, until the children reach the age of 18.  The IRA contributions to an education IRA (now called a Coverdell IRA) are nondeductible, and the funds can be withdrawn from an education IRA without paying taxes as long as the money is used for educational reasons.

Coverdell IRA Contributions

When the IRA was called the education IRA, the annual contribution was limited to $500.  Now, under the new qualifications of the education IRA in the revamped Coverdell IRA, the contributions have been increased to $2,000.

The original education IRA was extremely strict, with limited time periods when you could make IRA contributions, and limited qualified expenses that the money could be used for.  The Coverdell IRA offers more time to contribute money, (you can add money into the Coverdell IRA right through the April tax filing deadline) and you can use the funds for many more types of educational expenses.  You can even combine the money from your Coverdell IRA with other education tax breaks (like the 529 savings plan).

Education IRA Benefits

When an education Coverdell IRA is set up, a child under the age of 17 is used as the beneficiary of the account.  IRA contributions to a Coverdell IRA are not tax deductible- but when the contributions and the IRA's earnings are withdrawn they are taken tax-free as long as the money is used for qualified educational costs.

Any adult is eligible to make IRA contributions into the child's account, not just the child's parents or guardians, provided the total contribution isn't greater than $2,000. 

Money from an education Coverdell IRA can be used for some expenses other than tuition- including room and board, computers for college (or even for elementary or secondary schools), and books.

Education IRA contributions for the same child can be invested into both the Coverdell account and into a state college tuition program.

Where do you get an Education IRA?

Once you've decided that the Coverdell IRA is the way to go for your educational savings plan, how do you open one?  There are numerous providers that handle the Coverdell IRA.  Banks, brokerage companies, investment companies-  basically any company that handles a Traditional IRA can also set you up with an education Coverdell IRA. 

A Coverdell IRA investment allows you to make IRA contributions into the investment of your choice- such as bonds, mutual funds, CD's, or stocks.  As with any type of investment, it's a good idea to diversify your investment.  A student can have more than one Coverdell IRA, although the total of all IRA contributions must be $2,000 or less per year, no matter how many accounts a child has.

What if the Child Doesn't Go to College?

If you've set up an education IRA for a child who decides not to go to college, then the money cannot be withdrawn tax free.  What happens?  When the child turns 30, he or she must take out the balance in the account with 30 days of his or her birthday, pay tax on the earnings and also pay a 10% penalty for taking the money for noneducational purposes.

If the individual would like to avoid the 10% penalty and the tax required on the earnings, he or she can simply rollover the entire Coverdell IRA balance into a new Coverdell plan in an under 17 years old, family member's name (son or daughter, nephew or niece, or a younger sibling).