Coverdell Education Savings Accounts: Everything Parents Need to Know About Them

When saving up to put a kid through college, parents have a variety of options. They can, of course, save money the old-fashioned way -- in a bank savings account, with certificates of deposit, or money under the mattress. But in an effort to promote saving for college, the government has also created a handful of tax-advantaged ways to save -- most notably "529" qualified tuition plans and Coverdell education savings accounts.

Today, I'll focus on the latter, while also touching on the former.

A Coverdell ESA college fund can help to pay for everything in this pile. Image source: Getty Images.

What is a Coverdell education savings account?

The IRS  defines a Coverdell education savings account (ESA) as "a trust or custodial account created or organized in the United States only for the purpose of paying the qualified education expenses of the Designated beneficiary ... of the account."

Here's quick primer on the rules governing a Coverdell ESA:

• It must be established before the intended beneficiary (i.e., the future college student) reaches age 18.
• You can open a Coverdell ESA at a bank or similar "entity approved by the IRS."
• You can deposit no more than $2,000 a year in it.
• There are income limits. You can only deposit money in it at all if you earn less than $110,000 in the year ($220,000 if married filing jointly).
• This money must be used to pay only "qualified higher education expenses or qualified elementary and secondary education expenses." At the "higher education" level, this includes expenses (tuition, fees, books, and other supplies) of colleges and vocational training institutes, whether public or private, non-profit or for-profit. At the "elementary and secondary education" level, Coverdell ESA funds could be used to, for example, pay for private school tuition from grades K-12. Religious school expenses also qualify in this respect. The ESA's funds can be used to cover room and board for students living on campus at least half-time.
• And all the money in the account must be distributed (i.e., paid out) by the time the beneficiary reaches age 30.

Read the fine print

Do you like how these benefits sound so far? Wondering what other rules you need to be aware of? Well, there are several, but nothing insurmountable. 

First, contributions to a Coverdell education savings account are not tax-deductible. Once deposited, however, those funds can be invested much like funds in an IRA. And like an Roth IRA, profits earned from monies deposited in a Coverdell ESA are not taxed. They can grow without fear of the tax man, and if they're used for the beneficiary's education, they won't get taxed even when you withdraw them.

Another caveat worth noting is that Coverdell ESAs have a sort of use-it-or-lose-it feature. Yes, if they haven't been spent on education already, you can distribute the funds at age 30. But you really want to spend your Coverdell ESA money before that, because if you wait to age 30, the monies distributed then will incur a 10% penalty to the IRS, plus the capital gains from the account will become taxable.

The best of both worlds: Coverdell ESAs and 529 plans

Now for the big question. Coverdell education savings accounts have some interesting advantages over 529 plans, such as the ability to use Coverdell ESA funds to pay for private elementary and high school education. 529s have other benefits,  most notably, the fact that some states will make 529 contributions tax deductible, and other states will even give you a tax credit for 529 contributions.

So, can you have both?

The answer is yes, you can open both a Coverdell ESA and a 529 plan for your college-bound kid. Or you could open both and use the Coverdell to pay for private school before college and the 529 to pay for college later. And given all the benefits that the government is offering for both kinds of accounts, you probably should.