Guide to Education IRAs

There are many different ways you can save for a child’s future 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 — now formally known as Coverdell Education Savings Accounts (ESAs).

Education IRAs, or ESAs, provide a tax-advantaged way to save for primary, secondary, and higher education expenses. Unlike 529 plans, you can only save up to $2,000 per year, per beneficiary, in an ESA, and your contribution limit is determined by your income. What follows is a closer look at how ESAs work, their pros and cons, and how they compare to other college savings vehicles.

What Is an Education IRA, or ESA?

A Coverdell Education Savings Account (ESA) was formerly known as an “education IRA” because it functions similarly to a Roth IRA, where contributions are made with after-tax dollars and growth is tax-free. However, an ESA is a tool for college savings rather than retirement.

ESA Basics

An ESA is a tax-advantaged trust or custodial account designed to help families pay for qualified education expenses, including elementary, secondary, and higher education. Contributions grow tax-deferred and withdrawals are tax-free if used for qualified expenses. The account has a maximum annual contribution limit of $2,000 per beneficiary.

Parents, grandparents, and other guardians can make nondeductible contributions to an ESA for children under 18. However, the limit stays at $2,000. 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 funds from an ESA can be used to cover tuition, books, and uniforms for elementary school, high school, or college/graduate school.

How Do Coverdell ESAs Work?

ESAs have two primary people involved — the custodian, who manages the account, and the beneficiary, or student. The custodian sets up the ESA and manages the funds on behalf of the student beneficiary.

A Coverdell ESA is a type of self-directed account, where the custodian can invest the money in a variety of assets like stocks, bonds, real estate or mutual funds. The income and interest earned in the account is tax-deferred, which means that appreciation is not subject to taxes. Distributions for qualified educational expenses are also not subject to taxes.

ESA Rules

Here are a few of the rules for setting up Coverdell ESAs:

Funds Must Be Contributed Before the Beneficiary Turns 18

All funding to an ESA must be contributed before the child turns 18 years old, unless they’re a special needs beneficiary, per the IRS.

Funds Must Be Distributed Before Age 30

You generally must distribute all funds in an ESA before the beneficiary turns 30. If the funds are not used for qualified education expenses before that point, the account must be closed and assets paid to the beneficiary. In this case, a portion of the earnings will be taxable to the beneficiary, and a penalty will also be charged. To avoid taxes and penalties, the IRS allows funds to be rolled over into a new Coverdell ESA for another eligible family member who is under the age of 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 and $110,000 ($190,000 and $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 ESA are considered tax-advantaged. You do not pay any taxes on any interest and earnings that accrue in the account over time. 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% penalty.

Pros and Cons of a Coverdell ESA

Pros of an ESA	Cons of an ESA
Withdrawals for qualified education expenses are tax-free	Limited to $2,000 in contributions per year
Contributors can choose their own investments	Ability to contribute is limited by contributors’ MAGI
Can be used for educational expenses from kindergarten through college/graduate school	Can’t contribute after the beneficiary reaches age 18*
Certain transfers of an ESA to a different family member are permitted.	You generally must distribute all funds before the beneficiary turns 30.

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 tax-deferred and withdrawals are free from federal (and often state) income tax when used for qualified expenses like college tuition, fees, books. In contrast to ESAs, 529 plans allow generous contributions — up to full education costs, as defined by the state — and are not limited by the contributor’s income or student’s age. However, 529 plans generally offer more limited investment options compared to ESAs.

Roth IRA

A Roth IRA is a tax-advanted account designed to help individuals save for retirement. You fund the account with after-tax dollars, but your contributions and earnings grow tax-free. While designed for retirement, it’s also possible to tap a Roth IRA to cover education expenses.

Once you reach age 59½ (and it has been at least five years since you first contributed to a Roth), all money can be withdrawn tax- and penalty-free for any reason, including paying for children’s or grandchildren’s college expenses. If you withdraw funds to cover a child’s education (or any other) costs before that, however, the amount you withdraw that comes from your earnings will incur taxes.

High-Yield Savings Account (HYSA)

You can also use a high-yield savings account to save for college, though it’s typically viewed as a supplemental tool rather than a primary vehicle like a 529 plan or ESA.

Unlike investment-based accounts, HYSAs are not subject to market volatility. You can also withdraw funds at any time for any reason — such as books, rent, or emergencies — without the penalties associated with specialized education accounts. However, HYSAs don’t offer any tax advantages and, while safer, they may provide lower returns than stock market-based investments over the long term.

The Takeaway

An education IRA, officially known as a Coverdell Education Savings Account (ESA), offers a tax-advantaged way to save for a child’s qualified education expenses, from kindergarten through graduate school. While the annual contribution limit is relatively low at $2,000 per beneficiary and is subject to income restrictions, ESAs provide investment flexibility that other options, like 529 plans, may not. When planning for education savings, it’s essential to weigh the ESA’s limits and benefits against alternatives like 529 plans, Roth IRAs, and HYSAs to choose the best strategy for your financial situation.

FAQ

Is an education IRA the same as a 529 savings plan?

No. While both education IRAs (now called Coverdell Education Savings Accounts, or ESAs) and 529 savings plans both allow for tax-free growth and tax-free withdrawals for qualified education expenses, they are not the same thing.

ESAs have an annual contribution limit of $2,000 per beneficiary, while 529 plans allow contributions limited to education costs (as defined by the state). ESAs also have income limits, whereas 529 plans do not. In addition, ESA contributions must generally stop when the beneficiary turns 18, and funds must usually be used by age 30. By contrast, 529 plans do not have any age limits. It may be helpful to consult with a qualified tax advisor or attorney about your specific needs.

What are the benefits of an education IRA?

An education IRA (now called a Coverdell Education Savings Accounts, or ESA) 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?

Income limits for education IRAs, now known as Coverdell Education Savings Accounts (ESAs), are based on the modified adjusted gross income (MAGI) of the contributor. Currently, single taxpayers with a MAGI of $95,000 or less (and joint filers with a MAGI of $190,000 or less) can contribute the full $2,000 annual limit. A phaseout rule applies to single taxpayers with a MAGI between $95,000 and $110,000 ($190,000 and $220,000 for joint filers), resulting in a reduced contribution limit. Single taxpayers and joint filers whose MAGI exceeds $110,000 and $220,000, respectively, are ineligible to contribute.

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Photo credit: iStock/Jacob Wackerhausen

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