A Coverdell education savings account (also known as an education savings account, a Coverdell ESA, a Coverdell account, or just an ESA, and formerly known as an education
individual retirement account
An individual retirement account (IRA) in the United States is a form of pension provided by many financial institutions that provides tax advantages for retirement savings. It is a trust that holds investment assets purchased with a taxpayer's ear ...
), is a
tax advantage
Tax advantage refers to the economic bonus which applies to certain accounts or investments that are, by statute, tax-reduced, tax-deferred, or tax-free. Examples of tax-advantaged accounts and investments include retirement plans, education saving ...
d investment account in the U.S. designed to encourage savings to cover future education expenses (elementary, secondary, or college), such as tuition, books, and uniforms (for the same year as the distribution). It is found at Section 530 of the
Internal Revenue Code
The Internal Revenue Code (IRC), formally the Internal Revenue Code of 1986, is the domestic portion of federal statutory tax law in the United States, published in various volumes of the United States Statutes at Large, and separately as Title 26 ...
(). Coverdell ESAs were first introduced under the Taxpayer Relief Act of 1997.
The account is named for its primary champion in the
United States Senate
The United States Senate is the upper chamber of the United States Congress, with the House of Representatives being the lower chamber. Together they compose the national bicameral legislature of the United States.
The composition and pow ...
, the late Senator
Paul Coverdell
Paul Douglas Coverdell (January 20, 1939 – July 18, 2000) was an American politician who served as a United States senator from Georgia, elected for the first time in 1992 and re-elected in 1998, and director of the Peace Corps from 1989 until ...
(R-GA).
Structure and Tax-Advantaged Status
Structure
Coverdell ESAs have two primary parties: a
trust
Trust often refers to:
* Trust (social science), confidence in or dependence on a person or quality
It may also refer to:
Business and law
* Trust law, a body of law under which one person holds property for the benefit of another
* Trust (bus ...
or
custodian
Custodian may refer to:
Occupations
* Janitor, a person who cleans and maintains buildings
* Goalkeeper, in association football
* Fullback, in rugby, also called a sweeper
* Legal guardian or conservator, who may be called a custodian in some ...
, who manages the account, and a beneficiary, who receives distributions from the account. The trust or custodian is the party that establishes and controls the funds in the ESA for the student beneficiary, who must be under the age of 18 at the time of designation. Funds within the account are not considered to be owned by the custodian nor by the beneficiary unless they are the same individual. All funds within an ESA must be distributed to the beneficiary before he or she turns 30 years old, but the custodian may name a new beneficiary of the account before such time in order the preserve the account.
Coverdell ESAs are self-directed investment accounts. Unlike bank
deposit accounts, such as checking or savings accounts which are pure cash holdings and are typically insured, ESAs can contain both cash and investment
securities
A security is a tradable financial asset. The term commonly refers to any form of financial instrument, but its legal definition varies by jurisdiction. In some countries and languages people commonly use the term "security" to refer to any for ...
such as stocks, bonds, real estate funds, and mutual funds. The value of these securities is not insured. This means the value of the funds in an ESA may rise and fall with the respective values of the securities held in the account. Coverdell ESAs may be opened with any
investment brokerage institution who select a wide range of securities for the custodian to choose. The investment options for an ESA are therefore only limited by the choices available at that institution.
Tax-Advantaged Status
The funds contained in Coverdell ESAs are classified as
tax-deferred Tax deferral refers to instances where a taxpayer can delay paying taxes to some future period. In theory, the net taxes paid should be the same. Taxes can sometimes be deferred indefinitely, or may be taxed at a lower rate in the future, particular ...
. This means the appreciation, interest, and profits of securities within the account are not taxed as
capital gains
Capital gain is an economic concept defined as the profit earned on the sale of an asset which has increased in value over the holding period. An asset may include tangible property, a car, a business, or intangible property such as shares.
...
or income. Qualified distributions from an ESA are tax-free and are not considered income to the beneficiary, nor are contributions to ESAs tax-deductible. However, if the beneficiary receives an ESA distribution that exceeds his or her total qualified expenses in a given year, the excess is taxed as
normal income. Any excess distribution that results from distributing the remainder of the account once the beneficiary turns 30 years old is also taxed as normal income.
Contributions and Distributions
Contributions
There are no restrictions on who can make qualified contributions to a Coverdell ESA, but there are limits on how much. Each ESA plan can only receive a total of $2,000 in contributions per tax year. Individuals may contribute to any number of accounts per tax year as long as each plan does not exceed the $2,000 contribution limit. Contributors with a higher
modified adjusted gross income
In the United States income tax system, adjusted gross income (AGI) is an individual's total gross income minus specific deductions. It is used to calculate taxable income, which is AGI minus allowances for personal exemptions and itemized deduc ...
, or MAGI, of $95,000+ for single tax filers or $195,000+ for joint filers may not contribute the full $2,000 limit. Single tax filers exceeding a MAGI of $110,000 or joint filers exceeding $220,000 may not contribute to Coverdell ESAs at all.
Distributions
The beneficiary may request, or the custodian may elect, to use Coverdell ESA funds to pay for qualified educational expenses. Qualified expenses include, but are not limited to, tuition and fees, books and supplies, room and board, and some special needs services if required by the student. Qualifying educational institutions include all accredited primary and secondary schools, including private or religious institutions, and post-secondary institutions that are eligible to receive federal
financial aid
Student financial aid in the United States is funding that is available exclusively to students attending a post-secondary educational institution in the United States. This funding is used to assist in covering the many costs incurred in the p ...
. There are no restrictions on the amount of qualified funds that may be distributed within a given year and distributions are purely voluntary.
Comparison to a 529 Plan
Coverdell ESAs have many similarities and differences to a
529 Plan
5 (five) is a number, numeral and digit. It is the natural number, and cardinal number, following 4 and preceding 6, and is a prime number. It has attained significance throughout history in part because typical humans have five digits on eac ...
, another tax-advantaged investment account aimed at helping students pay for their education. ESA's and 529s are the only two types of tax-advantaged educational accounts currently allowed by the U.S. tax code.
Effects
Since Coverdell ESAs are tax-advantaged, they impact federal tax revenues. The annual revenue lost to the IRS is small at about $100 million per year, or roughly less than 10 times less than the revenue loss generated by 529 plans. ESAs also reduce federal government expenditures since savings assets such as Coverdell accounts typically lower the amount of financial aid a student is eligible to receive. The impact of this reduction of federal student aid impacts students and their families differently. When the student is a dependent and not an owner of the account, money in both a Coverdell ESA and a 529 plan is not considered the child's (beneficiary's) money when applying for federal financial aid. The child's potential financial aid is increased compared to when the student is not a dependent and the account owner, because the
expected family contribution In the post-secondary education system of the United States, an expected family contribution (EFC) is an estimate of a student's, and for a dependent student, their parent(s)' or guardian(s)', ability to pay the costs of a year of post-secondary ed ...
will be 5.64% as opposed to 20%. Students belonging to higher-income households face a smaller relative impact than those coming from lower-income households, thus increasing the disparity in financial aid as a result of income.
[Dynarski, Susan. "Who Benefits From The Education Saving Incentives? Income, Educational Expectations And The Value Of The 529 And Overdell," National Tax Journal, 2004, v57(2,Jun), 359-383.]
See also
*
Outline of finance
The following outline is provided as an overview of and topical guide to finance:
Finance – addresses the ways in which individuals and organizations raise and allocate monetary resources over time, taking into account the risks entailed ...
References
{{Reflist
External links
* https://www.irs.gov/publications/p970/ch08.html — also available as a pdf from the IRS website as part of publication 970
Congressional Research Service (CRS) Reports regarding Education Savings Accounts
Internal Revenue Code
Personal finance
Education finance in the United States
Tax-advantaged savings plans in the United States