An Education Savings Account offers an appealing package of investment options, tax-free earnings, and generous allowed use. Find out why it is worth consideration as part of your college saving strategy.
What Exactly Is an ESA?
The Coverdell Education Savings Account (ESA)—formerly called an Education IRA—is a trust (or custodial) account designed for college savings. An ESA is set up on behalf of a child, who is the beneficiary—the one who benefits from the money saved. Technically, the student owns the assets in the account, but since the student is a minor, a parent acts on his or her behalf. There is no tax on earnings if the money is used to pay for the qualified education expenses of the student at an eligible postsecondary institution (one approved to offer federal student aid).
What Can It Pay For?
Basically, an ESA covers most college expenses. Eligible expenses include costs incurred for tuition, reasonable room and board (if attending at least half-time), books, and technology (if required). An ESA can also pay for similar expenses for the student's elementary or secondary school. Parents may even roll over ESA money to a 529 plan.
But think ahead before withdrawing ESA money:
- You need to make sure the expenses haven't been covered by other tax-free aid (such as a Pell Grant).
- You need to make sure that you haven't claimed all of the education expenses already to qualify for an education tax credit. If so, you must subtract these expenses from your total "qualified" expenses and withdraw only the remaining balance from the ESA.
What's This About Only $2,000 Per Year Per Student?
That's right. All contributions to the student's ESA from every source can only add up to $2,000 per year. There is six percent tax on anything over that. But if an ESA is set up many years before college starts, the yearly $2,000 can earn a high return over time, especially since all interest is potentially tax-free.
How Can the Money Be Invested and Who Controls the Investment?
ESA funds can be invested in any vehicle except life insurance. The parent or guardian controls the investment of the assets on behalf of the student.
Who Can Put Money Into the ESA?
To be eligible to contribute to an ESA, you must earn less than $220,000 (if filing jointly) or $110,000 (if filing single). The amount you are allowed to contribute depends on your income level. Joint filers making less than $190,000 or single filers making less than $95,000 may contribute the maximum $2,000 per year, per student to an ESA. Joint filers who make $190,000–$220,000 (or single filers who make $95,000–$110,000) are allowed to contribute lower amounts, depending on their income. Those with incomes too high to qualify for an ESA can open an account in their child's name.
How Does the Tax-Free Part Work?
It's simple. When money is withdrawn to pay for college, the earnings are not taxed if they are used for eligible college expenses. The deposits are tax-free because they are after-tax money. The money can't be taxed again upon withdrawal.
How Do ESAs Affect Financial Aid?
ESA's belonging to parents or dependent students are counted as parental assets by both the Federal Methodology (used by public and private colleges to determine eligibility for federal and state aid) and the Institutional Methodology (used by some private colleges to determine aid eligibility from its own resources). Parental assets have a smaller impact on financial aid eligibility than student assets. Withdrawals are not reported as student or parent income as long as they are used for qualified expenses. For more information on how student and parent assets contribute to financial aid, see the article Does It Matter Whose Asset It Is?
How Does the Student Qualify?
The beneficiary must be under 18 when the account is opened. No further contributions are allowed after that age. To avoid tax penalties, the funds must be withdrawn to pay for college before the student turns 30.
Other rules include:
- The student does not have to be related to the person who opens the account or contributes to it.
- When the student reaches adult age, the student can take control of the funds by notifying the account custodian (e.g., the bank). However, for maximum financial aid benefits, the account is best left with the parent acting on behalf of the student.
- If the original beneficiary does not go to college, beneficiary status may be transferred at any time to any other eligible person related to the original beneficiary. The money cannot revert to the owner.
- Exceptions are made for special needs students.
ESA Investment Strategy
ESAs should not be a last-minute method of paying for college. The sooner an account is opened, the better. If started early, ESAs are an excellent savings option, especially if you also use other savings vehicles such as 529 education saving plans.
Note: Financial information provided on this site is of a general nature and may not apply to your situation. Contact a financial or tax advisor before acting on such information.