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Education Savings Accounts

With a Coverdell education savings account (ESA), you can make after-tax contributions and accumulate tax-free earnings. Any amount you withdraw from the account to pay qualified education expenses for the account's beneficiary are tax free. And the range of qualified expenses that you can cover for the beneficiary includes nearly all of the costs of going to college.

But, like all tax-advantaged programs, ESAs come with restrictions.

Within the Limits

There are three key ESA limitations:

  • The total contribution for any one beneficiary can be no more than $2,000 a year, no matter how many people contribute.
  • There are income limitations. To be eligible to contribute, your adjusted gross income (AGI) must be less than $95,000 if you're single - or $190,000 if you're married and filing a joint return. Above those levels, the amount you can contribute begins to phase out.
  • The beneficiary you name must be younger than 18, and the money must be spent before they are 30. However, you can switch an ESA beneficiary to another member of the same extended family as long as you chose this option when you opened the account.

Getting Started

Most financial institutions that offer individual retirement accounts (IRAs) also offer ESAs. Major considerations will be the range of investments you want to make and the costs of opening the account and trading investments.

Make sure you understand the bank or brokerage's rules about who controls the account after the beneficiary reaches majority. In some plans, the responsible party - almost always the beneficiary's parent or guardian - oversees the account as long as it exists. For some, you have the right to turn over management to the student at the age of majority, which is between 18 and 21, depending on the state. In others, the student has the right to assume control at majority.

Spending the Money

ESA withdrawals are completely tax free as long as you use the money for qualified expenses for students enrolled in an eligible program. This means grades K to 12, full-time or part-time undergraduate, graduate, or professional studies at degree-granting colleges and universities, as well as certificate courses at vocational and technical schools.

Qualified expenses include tuition, books, supplies, and equipment for anyone in an eligible public, private, or for-profit institution, plus room and board if the student is enrolled at least half-time.

Managing an ESA

Unlike 529 college savings plans, ESAs let you to invest in any combination of stocks, mutual funds, ETFs, or other products available through your financial institution, allowing you to customize your ESA portfolio to suit your needs and the level of risk you're willing to take, while keeping in mind that investments can have losses, even in an ESA. You can also change the investments as you think appropriate. There are no taxes due when you buy and sell, but you will probably owe transaction costs.

You can roll over one ESA into another one as often as once a year without owing income taxes, as long as the ESA that you're moving to has the same beneficiary or one who is a member of the same family.

The Tax Pinch

If you use money you withdraw from an ESA to pay nonqualified expenses or expenses that are covered by withdrawals from another tax-free plan, the earnings portion of the withdrawal is taxed at the same federal rate that applies to your ordinary income. In addition, a 10% tax penalty is due. State taxes may also apply.

If a beneficiary turns 30 and you haven't named a new one, the money will be paid out, with some withheld for the taxes and penalty. The only exception to the age limit is if the beneficiary has special needs.

You should also be aware that the beneficiary could face a 6% tax penalty on contributions above the annual maximum of $2,000, though there's no tax due if the excess amount plus earnings is withdrawn by April 15 of the year following the year the money was deposited in the account. That's why it's important for beneficiaries to check the contribution reports they receive each year from institutions holding an ESA in their names. Any excess amounts will be included in calculating your tax bill.