Coverdell Education Savings Account

Learn how education savings accounts (ESAs), a tax-advantaged way to save for college expenses, can help you save for your child's educational costs.
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College is extremely expensive these days. Using an education savings account (ESA), sometimes called a Coverdell Education Savings Account, is a tax-advantaged strategy for saving for college that can help make today’s educational costs easier to manage.

Historically, this product has been popular with people in high tax brackets (read: wealthy folks). But you don’t have to be rich to benefit from an ESA.

What Is an Education Savings Account?

ESAs are a regulated investment, so you must follow certain rules. The money put into this type of savings account must be for a specific person (such as your son or daughter), and a “responsible individual” must be named on the account.

In order to be eligible to contribute to an ESA, your adjusted gross income for the year in question must be no more than $110,000 if you are single and $220,000 if you are married. You can set up an ESA for yourself. The maximum contribution is $2,000 per year.

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Are Contributions to Education Savings Accounts Tax Deductible?

Contributions are not tax deductible when they are made, but earnings on the investment and the original investment can be taken out at college time with no tax. In this respect, an ESA is similar to a Roth IRA, except that there is no “early withdrawal” penalty for an ESA.

If you did withdraw money from an education savings account for a purpose other than college expenses, you would have to pay tax on the earnings but not on the contributions themselves.

Pros and Cons of an Education Savings Account

There are some compelling reasons to use an education savings account, but it’s always a good idea to weigh the benefits and drawbacks when considering how to put your money to work for you.

Pro: Grow Tax-Free Savings

As noted, the big draw of an ESA is the opportunity for money to grow without being taxed and then be withdrawn without being taxed. To take a simple example, if you put $2,000 into an ESA on the day your child was born, and the investment rose in value to $5,000 by the time your child headed off to college, you could take out the full $5,000 tax-free. In other words, you would be escaping the tax man to the tune of $3,000.

Generally speaking, the longer the time between the first contribution and the first withdrawal, the more the tax benefit can be. For this reason, education savings accounts are often used by grandparents to pay for their grandchildren’s college expenses. Of course, this logic assumes that the money invested in the ESA has been managed properly and increased in value over time.

Con: The Value May Not Increase

The big potential negative about education savings accounts has to do with the assumption that the money invested in an ESA will be managed properly and increase in value. This is far from certain in today’s stock market.

How to Invest in an ESA

The stock market has traditionally yielded better returns than any other investment over the last 50 years. You can also work with a financial manager to see that your contributions are directed toward investments that you favor, such as real estate or bonds.

In other words, your funds don’t stop being yours when you put them into an education savings account. You’re still the boss, so if the person managing your ESA isn’t listening to your needs, you should feel free to take your money elsewhere.

Andrew Freiburghouse brings a wealth of tax expertise to MoneyRates, drawing on seven years as a junior partner at Pronto Income Tax of California, Inc., where he prepared around 7,000 tax returns. His exceptional skills extend to representing clients before the IRS, notably reducing a taxpayer’s debt from $72,000 to $700. Now based in Brooklyn, NY, Andrew is leveraging his extensive experience to establish his own tax practice, continuing his commitment to providing exceptional financial guidance.
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