Coverdell Education Savings Account (ESA)

Definition

A Coverdell Education Savings Account (ESA) is a form of Individual Retirement Account (previously known as an Education IRA) that allows parents, relatives, or other eligible individuals to contribute up to $2,000 per year for each child up to the age of 18. This type of savings account is intended to cover future education expenses.

Key Characteristics:

Contributions are made with after-tax dollars and do not provide a tax deduction.
The assets in a Coverdell ESA can grow tax-free.
Withdrawals used for qualifying education expenses are also tax-free.
Contributions are phased out for married couples filing jointly with adjusted gross incomes (AGIs) between $190,000 and $220,000 and for singles with AGIs between $95,000 and $110,000.
Couples with AGIs over $220,000 and singles with AGIs over $110,000 are ineligible to contribute.

Examples

Parental Contributions: Jane and John, married with a combined adjusted gross income of $180,000, contribute $2,000/year to their daughter Emily’s Coverdell ESA. This money grows tax-free and can be withdrawn tax-free to pay Emily’s college tuition, books, and room and board.
Investment Growth: Michael opens a Coverdell ESA for his son, investing in a mix of stocks and mutual funds. Over 10 years, the account grows to $30,000. Michael can use these funds, without tax penalties, to pay for his son’s college expenses.

Frequently Asked Questions

Q1: Can grandparents contribute to a Coverdell ESA? A1: Yes, any eligible individual, including grandparents, can contribute to a Coverdell ESA as long as the $2,000 annual limit per child is not exceeded.

Q2: What happens if the funds are not used for education expenses? A2: If withdrawals are not used for qualifying education expenses, the earnings portion of the withdrawal is subject to income tax and an additional 10% penalty.

Q3: Are there any restrictions on how the invested money can be used? A3: Yes, the money in a Coverdell ESA must be used for qualifying educational expenses to benefit from tax-free withdrawals. These include tuition, fees, books, supplies, and room and board at eligible educational institutions.

Q4: What types of investments are allowed in a Coverdell ESA? A4: Funds in a Coverdell ESA can be invested in a variety of assets, including stocks, bonds, mutual funds, and other investments typically available in IRAs.

Q5: Can I continue contributing to the Coverdell ESA after my child turns 18? A5: No, contributions can only be made until the beneficiary reaches the age of 18, unless the beneficiary is a special needs individual.

Individual Retirement Account (IRA): A savings account with tax advantages that individuals can use to save and invest long-term.
Adjusted Gross Income (AGI): An individual’s total gross income minus specific deductions, used to determine tax bracket and eligibility for various tax benefits.
Qualified Education Expenses: Expenses required for the enrollment or attendance at an eligible educational institution, including tuition, fees, books, supplies, and room and board.

Online References

Suggested Books for Further Studies

Savingforcollege.com’s Family Guide to College Savings by Joseph F. Hurley
Finances for Kidz: Jamnagar, Primary Textbook - Kid-Friendly Finance including the Coverdell Education Savings Account by Neale S. Godfrey
The College Savings Resource Guide by Brian Safdari

Fundamentals of Coverdell Education Savings Account: Finance Basics Quiz

### Who is eligible to open a Coverdell ESA for a child? - [ ] Only parents - [ ] Only legal guardians - [ ] Only grandparents - [x] Any eligible individual > **Explanation:** Any eligible individual, including parents, guardians, grandparents, or other relatives, can open a Coverdell ESA for a child, as long as the total contribution limit is observed. ### What is the maximum annual contribution limit for a Coverdell ESA per child? - [ ] $1,000 - [x] $2,000 - [ ] $5,000 - [ ] $10,000 > **Explanation:** The maximum annual contribution limit per child for a Coverdell ESA is $2,000. ### At what income level do married couples start to see a phase-out for Coverdell ESA contributions? - [ ] $150,000 to $180,000 - [x] $190,000 to $220,000 - [ ] $220,000 to $260,000 - [ ] $90,000 to $110,000 > **Explanation:** Married couples filing jointly begin to see a phase-out in contributions when their adjusted gross income falls between $190,000 and $220,000. ### Are contributions to a Coverdell ESA tax-deductible? - [ ] Yes - [ ] Yes, only partially - [x] No - [ ] Only under certain conditions > **Explanation:** Contributions to a Coverdell ESA are made with after-tax dollars and are not tax-deductible. ### What happens to the earnings in a Coverdell ESA if not used for education expenses? - [x] They are subject to income tax and a 10% penalty - [ ] They are taxed but no penalty is applied - [ ] They must be transferred to another child’s ESA - [ ] They are subject to capital gains tax > **Explanation:** If the funds are not used for qualified education expenses, the earnings are subject to income tax and an additional 10% penalty. ### Can the funds in a Coverdell ESA be invested in mutual funds? - [ ] No - [x] Yes - [ ] Only if the account holder is over 18 - [ ] Only for a maximum period of 5 years > **Explanation:** Funds in a Coverdell ESA can be invested in mutual funds, as well as other investment vehicles typically available for IRAs. ### What qualifies as a 'qualified education expense' for Coverdell ESA withdrawals? - [ ] Vacation trips related to education - [ ] Home renovations - [x] Tuition, fees, books, supplies, and room and board - [ ] Electronic gadgets not used for education > **Explanation:** Qualified education expenses include tuition, fees, books, supplies, and room and board at eligible educational institutions. ### Up to what age can contributions be made to a child's Coverdell ESA? - [ ] 16 - [ ] 21 - [ ] 15 - [x] 18 > **Explanation:** Contributions can be made to a Coverdell ESA until the beneficiary reaches the age of 18, except for special needs beneficiaries. ### Are withdrawals from a Coverdell ESA for non-educational purposes allowed without any penalty? - [x] No, they incur income tax and an additional 10% penalty on earnings - [ ] Yes, they are tax-free - [ ] Yes, but only up to 50% of the account balance - [ ] No, they only incur a 5% penalty > **Explanation:** Withdrawals not used for eligible education expenses are subject to income tax and an additional 10% penalty on the earnings. ### Can a Coverdell ESA be transferred to another child without penalties? - [ ] No - [x] Yes, if the new beneficiary is a family member under age 30 - [ ] Only with IRS approval - [ ] Yes, but only once > **Explanation:** A Coverdell ESA can be transferred to another family member under age 30 without incurring taxes or penalties.

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