Alternate name: Coverdell Education Savings Account, Coverdell ESAAcronym: ESA
Qualified education expenses include anything required for the enrollment or attendance of the beneficiary at an eligible educational institution (primary, secondary, or higher education). For example, tuition and fees, books, uniforms, supplies and other equipment, and in some cases, the cost of room and board are qualified expenses. Public, private, secular, and religious schools are all considered eligible educational institutions.
How Does an Education IRA Work?
The education IRA was first established under The Taxpayer Relief Act of 1997 and was eventually renamed the Coverdell Education Savings Account. Contributions to an education IRA are made with after-tax income, which means they are non-deductible. The account earnings grow tax-deferred and the money you withdraw to pay for qualified education expenses is tax-free. If you withdraw funds for non-qualified expenses, you’ll pay a 10% penalty and the beneficiary pays tax, too. As with traditional IRAs, education IRAs come with some limits:
The account beneficiary must be under 18 (or be a special needs beneficiary) at the time the account is established. You can only contribute until the beneficiary turns 18 (except for special needs beneficiaries). Account assets must be used (or transferred to a new beneficiary, such as a younger child) before the beneficiary turns 30. Single filers with a modified adjusted gross income of up to $110,000 can contribute up to $2,000 annually. If you’re filing a joint return, your income must not exceed $220,000.
Education IRA vs. 529 Plan
The main advantage of an education IRA is that investment options are more diverse than with 529 plans. But 529 plans allow you to contribute more annually - individuals can put in up to $15,000 per year (or $30,000 for couples) before incurring a gift tax. Also, the beneficiary of a 529 plan can be anyone, of any age, and can even be the same as the owner of the account. You can contribute to both accounts for the same beneficiary in a single year.
How Do Education IRAs Affect Financial Aid Eligibility?
Compared to other types of assets, ESAs offer more advantages when it comes to calculating financial aid eligibility. However, assets in an education IRA receive different treatment on the Federal Application for Financial Student Aid (FAFSA), depending on who owns the account. In most cases, keeping the account under the legal parent or guardian’s name or the beneficiary is best. In both cases, up to 5.64% of the account value will be included as an asset in the student’s Expected Family Contribution (EFC). If a grandparent or someone else owns the account, the account value doesn’t count as an asset. However, any withdrawals will be added to the student’s income on the following year’s FAFSA (up to 50% of the distribution amount).
