What it means
The account was introduced in the late 1990s as a way for families to save for education, and it was later renamed the Coverdell Education Savings Account. Despite the old name, it is not a retirement account, and the word IRA simply reflected the way it was structured.
People still use the old name, so it appears in older guides and in conversation. A parent, relative or friend can contribute to an account for a named child, up to an annual limit per beneficiary that is set by law and can change.
Contributions are made with money that has already been taxed, so there is no tax deduction when you put money in. The benefit comes later, because investment growth is not taxed while it stays in the account.
When the money is withdrawn to pay for qualified education expenses, the growth is generally tax-free. These expenses can cover tuition, books and certain other costs, and unlike some other plans, they can include school costs below college level.
If the money is not used for education, the growth may be taxed and may be subject to an extra charge. There are restrictions.
Eligibility to contribute can depend on the contributor's income, there is an age limit for the beneficiary, and funds generally have to be used or transferred by a certain age. Anyone using such an account should check the current rules with the tax authority or a qualified adviser, since limits and ages are set by law.
Compared with other education savings tools, such as 529 plans, the Coverdell account usually allows a wider choice of investments, but lower contribution limits. Families often compare the two, and some use both, depending on their goals.
Overall, the account is a simple example of how tax rules can reward saving for a specific purpose. The longer the money has to grow, the greater the value of the tax break.
In practice
Real-world examples.
Example
A grandparent opens an account for a newborn grandchild and puts in $5,000. Over the years the investments grow, and the family later uses the money for private school fees.
Example
A couple with two children opens separate accounts for each, so the savings are earmarked. When the older child starts college, the parents withdraw money to pay for tuition and textbooks.
Example
A family finds that their child received a scholarship and does not need all the money. They move the balance to a younger sibling's account, so it can still be used for education without a tax charge.
Formula
Calculation
Future value = Contribution x (1 + r)^n
Worked example of tax-free growth, using a lump sum:
Contribution: $5,000
Assumed annual return (r): 6%
Years (n): 10
Growth factor = 1.06^10, which is about 1.7908
Future value = $5,000 x 1.7908 = $8,954 (rounded)
Growth = $8,954 - $5,000 = $3,954
If this growth were taxed at an assumed 15%, the tax would be about $3,954 x 0.15 = $593. In a qualifying account used for education costs, that tax would generally not be due.
The annual contribution limit and any income limits are set by law, so a real plan should use the current figures. The arithmetic above uses an assumed return, which is not guaranteed and may be higher or lower in practice.Case study
Seen in the real world.
This is a fictional story. The Marlowe family, invented for this example, opened an education account for their daughter when she was born and invested $5,000. They assumed a 6% annual return, which was an assumption and not a promise.
After ten years the account was worth about $8,954 on that assumption, so about $3,954 was growth. The family kept the money invested and added further contributions each year within the annual limit.
When their daughter reached secondary school, they used part of the account to pay for a laptop and tutoring that qualified under the rules. Their adviser pointed out that they should confirm each year what the limits and qualifying expenses were, because the rules can change. The family and figures are illustrative.
Watch out
Common mistakes.
- Thinking the Education IRA is a retirement account. It is an education savings account despite the name.
- Assuming withdrawals are always tax-free. They are generally tax-free only when used for qualified education expenses.
- Using outdated limits. Contribution limits and age rules are set by law and can change, so check the current rules.
Questions
People also ask.
Is the Education IRA the same as a Coverdell account?
Yes. The Education IRA was renamed the Coverdell Education Savings Account.
Who can contribute?
Parents, relatives and others can contribute, although there can be income limits for contributors.
What happens to unused money?
It can often be moved to another eligible family member, but if it is withdrawn for other purposes the growth may be taxed and may carry an extra charge.
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