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What Is an Education IRA?
An education IRA is a tax-advantaged investment account for higher education, now more formally known as a Coverdell Education Savings Account (ESA). This savings vehicle lets parents and guardians make nondeductible contributions to an education IRA for children under 18.
Key Takeaways
- An Education IRA, now called a Coverdell ESA, is used to save for a child’s education expenses tax-free.
- Education IRAs have an annual contribution limit of $2,000 per beneficiary, with penalties for exceeding this amount.
- Funds in an Education IRA must be used or distributed by the time the beneficiary turns 30 to avoid taxes and penalties.
- Unlike 529 plans, unused Education IRA funds must be distributed to a child if not used for college.
- 529 plans allow contributions limited to education costs and can be used for various expenses, including tuition and housing.
How Education IRAs Work
Education IRA funds can cover tuition, books, and uniforms for elementary, secondary, and higher education. The funds in an education IRA can be withdrawn tax-free when they are needed for educational purposes.
Education IRAs are also called “Coverdell accounts” or “ESAs.” Although named “IRAs,” they are for education expenses, not retirement, but work similarly.
Education IRAs, renamed Coverdell ESAs in 2002, became more attractive when K-12 expenses were included. Like Roth IRAs, they allow annual, nondeductible contributions to a designated investment account. That investment grows free of federal taxes, and withdrawals are tax-free as well, as long as certain requirements are met related to the year’s contributions and the year’s withdrawals.
Key Rules and Considerations for Education IRAs
Education IRAs come with several rules and conditions, such as:
- You can’t fund an ESA after the beneficiary turns 18.
- Coverdell ESAs have a $2,000 annual contribution limit, with penalties for exceeding it.
- Low contribution limits mean small ESA maintenance charges might reduce returns.
- Unlike 529 plans, education IRA funds must be given to the child if not used for college.
- For federal financial aid, ESAs are like 529 plans and seen as a parent’s asset. Tax-free withdrawals aren’t counted as income.
- The account must be fully used by the beneficiary’s 30th birthday. Otherwise, taxes and penalties apply.
Comparing Education IRAs and 529 Plans
Both the educational IRA and the 529 plan allow plan holders to set up an account for a beneficiary of their choice. The tax treatment of education IRAs is similar to that of 529 savings plans, though with a few notable differences. Both allow for tax-deferred growth and for those proceeds to be withdrawn tax-free for qualified educational expenses at a qualified educational institution. Education IRAs are covered under Title 26, Subtitle A, Chapter 1, Subchapter F, Part VIII, Subsection 530 of the U.S. Code.
There is no limit to how many 529 plans a plan holder can set up. Contributions are limited to the cost of education, as defined by the state. Although accounts are set up for beneficiaries, they cannot lay claim to the funds. These plans can cover various expenses:
- The cost of tuition
- Eligible educational expenses such as equipment
- Related expenses such as meal plans and housing
The Tax Cuts and Jobs Act (TCJA) of 2017 made changes to the rules involving 529 plans. Plan holders can use up to a maximum of $10,000 to pay for K-12 tuition from public, private, or religious institutions per beneficiary each year—penalty- and tax-free.
Additional changes expanded the rules for 529 plans when the Setting Every Community Up for Retirement Enhancement Act (SECURE) was signed into law in December 2019. The owner of the account can withdraw up to $10,000 to use toward the payment of tuition and other related expenses for a beneficiary’s registered apprenticeship programs. Another change includes the ability for plan holders to withdraw a lifetime maximum of $10,000 to pay down a beneficiary’s qualified student debt.
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