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What is a Coverdell education savings account?
A Coverdell education savings account (Coverdell ESA) is a type of savings plan used to set aside money for education expenses. Coverdell ESAs build upon a previous individual retirement arrangement called an education IRA by expanding annual contribution limits from $500 to $2,000. Although similar to 529 plans, Coverdell education savings accounts differ in that they can be used to pay for grade school as well as higher education expenses.
Coverdell ESAs were named for the late Senator Paul Coverdell, and before 2001, they were known as education IRAs. As with other IRAs, contributions came out of pretax income and received tax-deferred growth. After education IRAs became Coverdell education savings account, they continued to function the same way, but had higher annual contribution limits: $2,000, instead of $500, per beneficiary. Additionally, Coverdell ESAs are not tax-deductible.
Coverdell ESAs help people save not only for college but also for elementary, middle, and high school, including tuition, books, room and board, uniforms, and transportation. These accounts are for future expenses: the beneficiary must be younger than 18 at the time the account holder starts saving, or have special needs. If the beneficiary hasn’t used the money by age 30, it will be disbursed back to the account holder.
There are income limits for savers who wish to open Coverdell accounts. As of the 2017 tax year, the threshold begins at a modified adjusted gross income (MAGI) of $110,000 for an individual taxpayer and $220,000 for joint filers. Account holders who earn more than that may be limited in their annual contributions.
Coverdell education savings accounts are similar to the 529 plan, another type of education savings arrangement. However, 529 plans have no annual contribution limits and may be deductible from the account holder’s state taxes. But Coverdell ESAs have an advantage over 529 plans in that the latter can only be used for higher education expenses, and Coverdell ESAs have more limited investment options.
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Coverdell education savings account example
Ethyl wants to open Coverdell ESAs for her two grandchildren. She opens each account with $2,000 and continues to make yearly contributions. One grandchild has the opportunity to attend a private elementary school and Ethyl can use the money to help cover the expenses associated with attending a private school for that grandchild. The other grandchild has no qualifying educational expenses until he attends college. Once he enrolls in college, his grandma can use his Coverdell account to pay for his college tuition.