What Is a Coverdell ESA?

A Coverdell Education Savings Account is a tax-advantaged savings account designed to help save for education expenses, including K-12 or higher education. There are, however, limits on who can participate and how much you can contribute each year.

A Coverdell Education Savings Account (ESA) is a tax-deferred savings account for educational expenses. You can use this account for K-12 and college expenses. Before you open an account, make sure you understand how it works and if you’re eligible.

With a Coverdell ESA, your contributions don’t lower your taxable income, but withdrawals used for eligible expenses (tuition, fees, college textbooks, supplies, and housing) are not taxed. So, any earnings growth is completely tax free when it comes time to pay for K-12 education expenses or college.

Coverdell ESAs are available at banks, credit unions, and brokerage firms. You can start by checking at financial institutions where you already have bank accounts. Just compare options to see which one has the best performing investment options and the lowest fees.

A 529 plan is another college saving plan to consider. Here’s how it stacks up against a Coverdell ESA so you can choose the best option for you.

A 529 savings plan doesn’t come with age restrictions. You can use the funds for undergraduate or graduate programs at any time. Or, they can be passed onto children to be used for their education expenses in the future.

Unlike a Coverdell ESA, anyone can contribute to a 529 plan, regardless of how much you earn each year. This makes it more accessible, and it can be a long-term savings vehicle even if your income grows in the future.

Another benefit of a 529 savings plan is that there’s no annual limit to how much you can contribute. With a Coverdell ESA, you can only fund up to $2,000 per year for each child. There is, however, the potential for a gift tax if a grandparent or other relative donates to a 529 savings plan. The annual gift tax exclusion for 2022 is $16,000, so anything above that amount will be taxed like income.

Coverdell ESAs help people who meet specific income requirements save for educational expenses. There’s also an annual contribution limit of $2,000 per child. Anyone can donate to a 529 plan, and there’s no limit to how much you can donate. Some state 529 plans do limit how the funds can be used, and may restrict them just to higher education. All Coverdell ESAs, on the other hand, allow people to use the funds for K-12 and college expenses.

Accounts are opened through a financial institution, such as a bank or brokerage firm. Contributions aren’t tax deductible, but withdrawals — including any investment earnings made — are tax free, as long as they’re used for eligible education expenses.

There are two options if the student doesn’t plan to use the ESA money before turning 30. The first is to transfer the funds to another eligible beneficiary (like a younger sibling) who will use the ESA money for their education. The other option is for the original student to withdraw the funds, which will trigger income tax on the earnings.

You can withdraw funds from a Coverdell ESA at any time. To avoid any income tax penalties, make sure you use the money for qualified distributions. This includes things like tuition, fees, books, and supplies.