There are many different ways you can save for education expenses, and each one comes with its own pros and cons. Depending on your situation, you may want to explore 529 college savings plans, Roth IRAs, or education IRAs — also known as Coverdell Education Savings Accounts (or ESAs).
Education IRAs — more commonly called Coverdell ESAs today — provide a tax-advantaged way to save for primary, secondary, and higher education expenses. Unlike 529 Plans, you can only save $2,000 per year, per beneficiary in an ESA, and your contribution limit is determined by your income.
What Is an Education IRA, or ESA?
Despite sometimes being called an education IRA, this is not a retirement account like a traditional IRA, but is rather intended for education-related expenses, including tuition, tutoring, books, and more.
It’s possible for a parent to consider using retirement funds to pay for college, but it’s generally unwise to compromise your own retirement.
Fortunately, there are many tax-advantaged ways to save for a child’s education. It’s even possible to use an education IRA in combination with a 529 plan, especially if you’re looking for creative ways to save for college.
ESA Basics
It’s important to know that different rules apply to each type of educational account. For example, parents, grandparents, and other individuals can open ESAs on behalf of an eligible beneficiary (the student) and make annual contributions.
But contributions are not tax deductible (as they sometimes are when creating a college fund, depending on the state); and contributions are limited to $2,000 per year, total, per beneficiary. So, if a grandparent opens an ESA for a child, and an uncle opens an ESA for the same child, the total contribution amount per year in those two ESA accounts cannot exceed $2,000.
The perks of a 529 savings plan include: No annual contribution limits; no income limits; contributions are tax deductible in some states. But you can only use up to $10,000 in 529 funds for primary and secondary education expenses.
How Do Education IRAs Work?
ESAs have two primary people involved — the custodian, who manages the account, and the beneficiary, or student. The custodian sets up the education IRA and manages the funds on behalf of the student beneficiary.
An education IRA is a self-directed account, where the custodian can invest the money in assets like stocks, bonds, real estate or mutual funds. The appreciation and interest earned in an education IRA is tax-deferred, which means that appreciation is not subject to tax on capital gains or income. Distributions for qualified educational expenses are also not subject to taxes.
ESA Rules
Here are a few of the rules for setting up education IRAs (i.e., Coverdell ESAs):
Funds Must Be Contributed Before the Beneficiary Turns 18
All funding to an education IRA must be contributed before the beneficiary turns 18 years old, unless they’re a special needs beneficiary per the IRS.
Funds Must Be Distributed Before Age 30
You must distribute all funds in an education IRA before the beneficiary turns 30 (again, this doesn’t apply to those with special needs). However, the custodian may name a new beneficiary if there are still funds in the account when the original beneficiary reaches age 30.
Contribution Limits
Each account may only receive $2,000 in funding each year, total. Additionally, if your modified adjusted gross income (MAGI) is between $95,000 to $110,000 ($190,000 to $220,000 for those filing jointly), you can contribute a partial amount, not the full $2,000. If your MAGI is above $110,000 (or $220,000 for joint filers), you are not permitted to contribute to an ESA.
Tax-free for Qualified Expenses
While contributions are not deductible, assets in an education IRA are considered tax-advantaged, which means you do not pay any capital gains or income tax over time on the money within the account. And as long as you withdraw the money for qualified education expenses, you won’t pay any taxes on the withdrawals either. Nonqualified withdrawals, however, are subject to taxes and a 10% tax penalty.
Pros and Cons of an Education IRA
| Pros of an Education IRA | Cons of an Education IRA |
|---|---|
| Withdrawals for qualified education expenses are tax-free | Limited to $2,000 in contributions per year |
| Are self-directed, meaning contributors can choose their own investments | Ability to contribute is limited by contributors’ MAGI |
| Can be used for educational expenses from kindergarten through college | Can’t contribute after the beneficiary reaches age 18* |
| Beneficiary of an ESA can be changed to a family member of the original beneficiary | Must distribute all funds before the beneficiary turns 30* |
*This does not apply to special needs beneficiaries.
Alternatives to Education IRAs
Here are a few alternatives to education IRAs:
529 Plans
A 529 plan is one of the most common ways that people save for college and other educational expenses. Earnings in 529 plans are also tax-deferred and qualified educational expenses can be withdrawn tax free, but in contrast to education IRAs, 529 plans have no limitations on the age of the beneficiary.
Roth IRA
You can also set up a Roth IRA for a child as a way to save for higher education expenses like college. While a Roth IRA is mostly intended for retirement savings, it can also be used for higher-education expenses because you can withdraw your contributions at any time (but there are restrictions on withdrawing investment earnings from a Roth before age 59 ½ ).
High-Yield Savings Account
It is also possible to put some or even the majority of your college savings money in a high-yield savings account. While you lose some of the tax advantages that come with Coverdell ESAs, IRAs, or 529 plans, you also have more flexibility since the money in a savings account can be used for any purpose without penalty. Also, these accounts are typically FDIC insured.
FAQ
Is an education IRA the same as a 529 savings plan?
While education IRAs (now called Coverdell ESAs) and 529 savings plans are both ways to save for education expenses, they are not the same thing. The aggregate contribution limits for 529 plans are much higher than they are for an ESA, so you could save more — and you’re not required to stop making contributions once your child turns 18.
What are the benefits of an education IRA?
An education IRA allows you to save money for a beneficiary and watch that money grow tax-free. And as long as you withdraw that money for qualified education expenses, you won’t ever have to pay income tax or capital gains tax on that money.
What is the income limit for an education IRA?
Education IRAs do limit who can make a contribution based on the adjusted gross income (MAGI) of the donor. Currently, the income limits for an education IRA are $95,000 for single taxpayers and $190,000 for married taxpayers. Single taxpayers with an MAGI of $95,000 to $110,000 and joint filers with an MAGI of $190,000 to $220,000 can contribute a lesser amount due to a phaseout rule. Single taxpayers and join filers whose MAGI exceeds $110,000 and $220,000, respectively, are not eligible to contribute to an educational IRA.
Photo credit: iStock/Jacob Wackerhausen
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