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Guide to Education Savings Accounts

Guide to Education Savings Accounts
Caroline Banton
Caroline BantonUpdated January 18, 2023
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An education saving account (ESA) is a way to save for a child’s education while taking advantage of tax benefits. The two primary types of ESAs are 529 plans and Coverdale accounts, and each comes with pros and cons. There are also other types of savings accounts – including ROTH IRAs and custodial accounts – that can be used to put aside money for college expenses.The right ESA for you will depend on a number of factors, including your income, whether you want to pay for college or K-12 expenses, and how much you want to put aside each year. Read on to determine which plan is best for you.

What Is an Education Savings Account? 

An educational savings account, or ESA, is an account that is designed to help parents pay for education expenses, including K-12, college, and graduate school. The contributions you make into an ESA are typically tax-deferred, which means you don’t pay any taxes on the earnings (a.k.a., growth) while the money is in the account. And, if you use the money for qualified education expenses, you can withdraw it completely tax-free.Qualified education expenses typically include tuition, room and board, fees, books, equipment, and supplies at an eligible elementary, secondary, and post-secondary school. If you use the funds to pay for elementary or secondary school, the cost of tutoring, uniforms, transportation, and supplementary items and services may also qualify.  

How Do Education Savings Accounts Work?

All college savings accounts maintain different eligibility requirements and restrictions and have different benefits. One of the most popular ways to save for a child’s college or K-12 education is a 529 plan. These savings plans are usually sponsored by state governments and many states will let you deduct your contributions from your state income tax. Your money will grow tax-free and, if you use the funds for qualified education expenses, you’ll never pay tax on the growth. You can put money into your own state's 529 or any other state's plan, and there is no annual limit on the amount you may deposit.A Coverdell ESA is another type of tax-deferred account that can be used to pay for elementary, secondary, and higher education expenses. Like a 529, earnings accumulate tax-free, and distributions are free of income taxes as long as the funds are used for educational purposes. You can’t put more than $2,000 a year into an Coverdell ESA, and they’re only available for families below a certain income level (more on that below). Recommended: How Much Does the Average American Have in Savings? 

Understanding Education Scholarship Accounts

To make matters somewhat confusing, there is another type of education saving account, sometimes referred to as an education scholarship account. These ESAs are funded by state governments and are designed to help parents withdraw their children from public school and pay private school tuition. They are offered by several, but not all, states.

Where Can I Find Education Savings Account Programs?

You can open up an ESA with many banks, credit unions, brokerage houses, and mutual fund companies.Recommended: Brokerage Account vs Savings Account 

What Benefits Do Education Savings Accounts Have for Students?

It’s no secret that college can be expensive. An ESA can make it possible for a student to attend college without graduating with large amounts of student debt.The advantage of using an ESA vs. a high-yield savings account or regular brokerage account to save for tuition is that you do not pay taxes on the earnings. And, as long as you use the funds for qualified education expenses, you won’t pay taxes on your withdrawals.Students who already have loans can also benefit from 529s. Thanks to the 2019 SECURE Act, you can now take out up to $10,000 from a 529 per year to repay student loans.

Things to Consider When Choosing Education Savings Accounts

To find the right ESA for your family’s needs, you may want to consider the following factors.

Eligibility Requirements

If you earn above a certain level of income, you may be ineligible to open or contribute to a Coverdell ESA. Higher earners looking for tax-deferred savings toward education might consider opening a 529 plan instead, since these accounts don't have an income restriction.

Contribution Limits

How much do you plan to put into your ESA each year? With a Coverdell ESA, you are generally limited to contributing no more than $2,000 each year per child. A 529 plan has no limit on annual contributions.

Distributions

If you plan to use the funds to cover primary or secondary school, you’ll also want to look at distribution limits. With a 529 you are limited to $10,000 per year when paying for qualified K-12 expenses (there is no limit on withdrawals used for qualified college expenses). Coverdell ESAs do not have any limits on educational expenses at elementary or secondary schools.Recommended: Guide to Transferring Money Between Banks 

Fund Selection and Fees

You may also want to look at investment options and fees that come with an ESA. With a 529 plan, you generally have a limited selection of funds to invest in. If you open a 529 through a broker, you may also pay management fees, which can eat into your returns.Contributions to Coverdell ESAs can be invested in virtually any stock, bonds, or mutual fund, making them a good choice for savers who want maximum control over how their funds are invested. Fees will depend on the investment vehicle you choose.

Education Savings Account Options

While you can use any type of savings account to save for education expenses, certain accounts can help your money grow faster. Here are some to consider.

529 Plans

With a 529, you invest after-tax dollars that grow tax-free and are not taxed when you withdraw them as long as the funds are spent toward qualified education expenses. There are plenty of options available, and you can open almost any state’s 529 plan no matter where you live or where the child wants to attend college.You can also use a 529 to pay for a child’s K-12 education expenses, but only up to $10,000 per year.

Coverdell Education Savings Accounts

Like a 529, a Coverdell ESA is a tax-advantaged account designed to help save for educational expenses. Contributions are made on an after-tax basis, but earnings aren’t taxed. When you withdraw the money and use it for qualified education expenses, the investment profits are 100% tax-free.Contributions are capped at $2,000 per year and you can only make them until your child turns 18. To open and contribute to a Coverdell ESA, your income must be below a certain limit ($110,000 for single filers; $220,000 for married couples). With a Coverdell ESA account, you can invest in a wide variety of products including stocks, bonds, and mutual funds.Coverdell ESA funds must be withdrawn when the beneficiary turns 30, or rolled over to another eligible beneficiary in the family.

ROTH IRA

While they’re not specifically designed for college savings, Roth IRAs can be used to pay for a child’s education. Like other college savings vehicles, Roth IRA accounts are funded with after-tax dollars and grow tax-free. You can withdraw money from a ROTH IRA for educational purposes without paying a penalty – though you’ll still have to pay income taxes on the earnings. If you withdraw the money after age 59 ½, however, you won’t pay any tax on those earnings. Money in a Roth IRA can be invested in stocks, bonds, exchange-traded funds (ETFs), index funds, and more, giving you plenty of options to customize your investment. And unlike ESAs, should your child not end up going to college or spending less than you expected on college, you can use the funds for your retirement. There are income and contribution limits with ROTH IRAs, however, which you’ll want to understand and consider before opting to use this type of account for college saving.

Custodial Account

Custodial accounts – also known as UGMAs (for the Uniform Gifts to Minors Act) and UTMAs (for the Uniform Transfers to Minors Act) – are created for your child and managed by you. These accounts can hold cash, stocks, and mutual funds, and there is no limit to how much money you can put into the account. Custodial accounts don’t offer the tax benefits of ESAs, but they can be used to fund expenses that those plans don't cover. However, this option generally works best with a child whom you believe is responsible. Your child will legally be able to use the money in the account – for college or anything else – when they reach "termination age" – typically 18, 21 or 25 depending on your state.Recommended: Average Savings Account Interest Rate 

What Is a Coverdell Education Savings Account and How Does It Work?

A Coverdell ESA is a tax-advantaged account used to save for a child’s educational expenses. You can contribute up to $2,000 into the account each year and the money will grow tax-free. And while saving for college is why many people use a Coverdell ESA, the account can also be used toward eligible K-12 expenses.

Coverdell Eligibility Restrictions and Age Limits

In order to open a Coverdell ESA, the beneficiary of the account must be under age 18 at the time, and the funds must be distributed once the beneficiary turns 30. There are also income limits on who can open a Coverdell account, and they depend on your modified adjusted growth income (MAGI) and filing status. If you file your taxes jointly and your MAGI is under $190,000 per year ($95,000 for single filers), you’re eligible to contribute the full amount. Those with a higher MAGI will see the amount they can contribute reduced. And if your MAGI is above $220,000 per year ($110,000 for single filers), you aren't eligible to contribute to a Coverdell ESA.

Minimum Initial Deposit and Yearly Maximum Contribution

The minimum initial deposit for a Coverdell ESA will depend on the type of account you open. You can have more than one Coverdell account for a beneficiary, but the total contribution to all accounts cannot exceed $2,000 per year. Similar to the rules concerning IRAs, you can make your annual contribution to an ESA up until the tax filing deadline for that year.Once the beneficiary turns 18, you can’t make any more contributions to the Coverdell account, unless the beneficiary has special needs.

Tips for Opening a Coverdell Education Savings Account

You can open a Coverdell ESA at many banks, credit unions, brokerage firms, and mutual fund companies. If a bank or investment institution offers IRAs, it will usually also offer Coverdell ESAs. Many financial institutions will charge an annual maintenance fee, and some may require a minimum opening and/or annual contribution, while others don’t. Mutual fund houses and brokerage firms typically offer more options and lower fees. It can be a good idea to shop around and compare Coverdell accounts to find one that will work best for your family’s needs.

Coverdell Education Savings Accounts vs. 529 Plans

Coverdell ESAs and 529s both offer tax advantages, but there are few key differences between these savings plans. One is how the money is invested. With a Coverdell ESA, you have myriad investment options, from stocks and bonds to mutual funds, while 529 plans limit you to whatever investments are offered by the state.Another key difference is contribution amounts. A Coverdell ESA limits the total amount you can contribute for a beneficiary to $2,000 a year. With a 529 plan, there are no limits. However, if you contribute more than $15,000 in one year per beneficiary ($30,000 for joint filers), you may be subject to gift taxes.There are also different eligibility requirements. You aren’t eligible to use a Coverdell ESA if your income exceeds $220,000 for a married couple and $110,000 for an individual filer. There are no income level restrictions with 529 plans.Control of the plan also differs. With the Coverdell ESA, the money must either be given to your child by their 30th birthday or transferred to a different family member. With a 529 plan, the funds and control of the plan are always in the hands of the donor and never the beneficiary.

The Takeaway

When it comes to saving for a child’s education, you have several options. If you don’t need to save a lot and want control over how your money will be invested, you might choose a Coverdell ESA. If you want to save more than $2,000 a year, you might prefer a 529. If your child may need to spend money on extra expenses that are outside the normal range of college students, a custodial account could work well. If you’re not sure whether your child will attend college, or what costs might be, you might consider using a ROTH IRA as your education savings account.

3 Money Tips

  1. Because online banks don’t have the overhead costs that brick-and-mortar banks have, they may offer a higher savings account interest rate. Just keep an eye out for minimum balance requirements and monthly fees.
  2. To get into the savings habit, consider having 10% of your paycheck directly deposited into your savings account. Or, set up a small automatic recurring transfer from your checking account into your savings account on the same day each month.
  3. To set up a simple monthly spending budget, consider the 50/30/20 rule. This involves splitting your after-tax income into three categories of spending: 50% on needs, 30% on wants, and 20% on savings.
Lantern can help you compare online savings accounts and find today’s best rate.

Frequently Asked Questions

Who is a Coverdell Education Savings Account best for?
How often can I withdraw from Coverdell?
Can a Coverdell account be transferred?
Where can you open a Coverdell Education Savings Account?
Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.
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About the Author

Caroline Banton

Caroline Banton

Caroline Banton is a finance and business writer whose work has appeared on sites such as The Huffington Post, Investopedia, The Motley Fool, LendingTree, MSN, and Time. With an MBA from Johns Hopkins University, Caroline has written for fintech companies, acted as a career coach, and ghost-written for prominent thought leaders in the financial industry.
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