A Coverdell Account Is a Tax-Sheltered Savings Account for Education Costs

A Coverdell Education Savings Account (ESA) is a savings account where money grows without being taxed, as long as you use it to pay for education expenses. You put after-tax money in, the account earns interest or investment returns, and when you withdraw it to pay for school costs, you pay no federal tax on the growth. The account is named after the person saving — usually a parent or grandparent — but the money is legally owned by the student.

The account works differently from a regular savings account because the money can be invested in stocks, bonds, or mutual funds, not just held as cash. This means the account can grow faster, but it also carries investment risk. If the stock market drops, the account value drops with it. You control how the money is invested and when it is withdrawn.

Coverdell accounts are small compared to other education savings tools. The annual contribution limit is $2,000 per student per year, and that limit is shared across all Coverdell accounts opened for the same child. If a grandparent opens a Coverdell and a parent opens another, the total contributions from both cannot exceed $2,000 in a single year.

Key Takeaways

  • You can contribute up to $2,000 per year per student to a Coverdell account, and contributions must stop by December 31 of the year the student turns 18.
  • Money in the account grows tax-free and withdrawals are tax-free when used for may have access to education expenses, including K-12 tuition and room and board at college.
  • If money is withdrawn for non-education purposes, you pay income tax on the earnings plus a 10 percent penalty, though the penalty does not apply if the student receives a scholarship or attends a military academy.
  • The account must be emptied by the time the student turns 30, or remaining funds are taxed and penalized.
  • Income limits apply to who can contribute: in 2024, the limit phases out between $190,000 and $220,000 for single filers and $190,000 and $220,000 for married couples filing jointly.

What Counts as a may have access to Education Expense

may have access to expenses include tuition and fees at any accredited K-12 school, public or private. They also include room and board if the student is enrolled at least half-time at a college, university, or vocational school. Books, supplies, equipment, and computer hardware and software used for education count as well.

Starting in 2024, up to $35,000 can be rolled over from a Coverdell account to a 529 plan when the student is no longer using the Coverdell. This rollover does not count against the annual $2,000 contribution limit for the 529 plan. The rollover must happen within 30 days of the Coverdell account being closed.

Expenses that do not count include room and board for students attending school less than half-time, transportation costs, and insurance. Athletic fees and club memberships do not count unless they are required by the school as part of enrollment.

Income Limits and Who Can Contribute

Not everyone can contribute to a Coverdell account. The IRS sets income limits based on your tax filing status and modified adjusted gross income (MAGI). For 2024, the income phase-out range is $190,000 to $220,000 for single filers and $190,000 to $220,000 for married couples filing jointly. If your income is above the phase-out range, you cannot contribute.

These income limits change each year and are adjusted for inflation. You can check the current year's limits on the IRS website or ask your tax preparer. If your income is too high to contribute directly, a grandparent or other relative with lower income can open and contribute to the account instead, as long as they have a Social Security number or tax ID for the student.

The person opening the account — the account owner — must be a U.S. citizen or resident alien with a valid Social Security number. The student beneficiary must also have a Social Security number and be under age 18 when the account is opened, with limited exceptions for students with special needs.

How to Open and Fund a Coverdell Account

You open a Coverdell account through a bank, brokerage firm, or mutual fund company. You will need the student's Social Security number, date of birth, and address. The account owner will need their own Social Security number and tax ID. Most financial institutions have an online form or paper application you can complete in minutes.

Once the account is open, you can contribute money at any time during the year, but all contributions for a given year must be made by December 31 of that year. You cannot make contributions after the student turns 18, except in cases where the student has special needs — in those cases, contributions can continue until age 30.

You decide how to invest the money once it is in the account. Some accounts offer preset portfolios that automatically shift from stocks to bonds as the student gets closer to college age. Others let you pick individual investments. If you do not choose an investment option, the money typically sits in a money market fund earning minimal interest.

What Happens to Money Not Used for Education

If you withdraw money from a Coverdell account for anything other than education expenses, you owe income tax on the earnings portion of the withdrawal, plus a 10 percent penalty. The principal (the money you contributed) comes out tax-free, but the growth is taxed. This can be expensive if the account has been open for many years and has grown significantly.

The 10 percent penalty does not apply in certain situations: if the student receives a scholarship, if the student attends a U.S. military academy, or if the student becomes disabled or dies. In these cases, you can withdraw the earnings without the penalty, though you still owe income tax on them.

If money remains in the account after the student turns 30, the account must be closed. Any remaining balance is distributed to the student, who owes income tax and the 10 percent penalty on the earnings. For this reason, it is important to plan withdrawals carefully and consider rolling unused money into a 529 plan before the student turns 30.

Coverdell Accounts Compared to 529 Plans

Coverdell accounts and 529 plans are both tax-advantaged education savings tools, but they work differently. A Coverdell has a $2,000 annual contribution limit and income restrictions. A 529 plan has no annual contribution limit (though there are aggregate limits per beneficiary that vary by state, typically $235,000 to $550,000), and most 529 plans have no income limits for contributors.

Coverdell accounts can be used for K-12 expenses, including private school tuition. Most 529 plans can also be used for K-12 tuition now, though some state plans have restrictions. Both allow tax-free growth and tax-free withdrawals for education expenses. Both also allow rollovers to another family member if the original beneficiary does not use all the money.

The main advantage of a Coverdell is flexibility: you control the investments directly, and you can use the money for a wider range of K-12 costs. The main advantage of a 529 is higher contribution limits and no income restrictions. Many families use both — a Coverdell for smaller, flexible savings and a 529 for larger contributions.

Tax Reporting and Record-Keeping

When you open a Coverdell account, the financial institution will issue a Form 5498-ESA each year showing contributions made to the account. You do not file this form with your tax return, but you keep it for your records. If you withdraw money, the institution will issue a Form 1099-Q showing the amount withdrawn and the earnings portion.

You are responsible for tracking which withdrawals are for may have access to education expenses and which are not. The financial institution does not know whether you spent the money on tuition or on something else — you must keep receipts and documentation. If the IRS audits your return, you will need to show proof that withdrawals matched education expenses.

If you have multiple Coverdell accounts for the same student, you must track the total contributions across all accounts to stay within the $2,000 annual limit. Exceeding the limit results in a 6 percent excise tax on the excess contribution each year it remains in the account, in addition to income tax and penalties on earnings.

Frequently Asked Questions

Can I open a Coverdell account for a grandchild or other relative?

Yes. Any adult with a valid Social Security number or tax ID can open and contribute to a Coverdell account for any student under 18, as long as the contributor's income is within the limits. Grandparents, aunts, uncles, and family friends can all open accounts. The student's Social Security number is required, but the account owner does not have to be a parent.

What happens if I contribute more than $2,000 in a year?

The excess contribution is subject to a 6 percent excise tax each year it remains in the account. You also owe income tax and a 10 percent penalty on the earnings attributable to the excess. It is important to track contributions across all Coverdell accounts for the same student and stay within the annual limit.

Can I move money from a Coverdell to a 529 plan?

Yes, starting in 2024, you can roll over up to $35,000 from a Coverdell to a 529 plan for the same beneficiary. The rollover must happen within 30 days of closing the Coverdell account and does not count against the 529 plan's annual contribution limits. This is a useful option if you have unused Coverdell funds and want to preserve them for education expenses.

What if my child does not go to college?

If the student attends a vocational or trade school instead of college, Coverdell funds can still be used for tuition, fees, books, and equipment. If the student does not pursue any post-secondary education, you can roll the money into a 529 plan for a younger sibling or relative, or withdraw it and pay income tax and a 10 percent penalty on the earnings.

Do Coverdell accounts affect financial aid?

Yes. Coverdell accounts owned by a parent are counted as a parental asset on the Free Application for Federal Student Aid (FAFSA), which can reduce the amount of need-based aid the student receives. Coverdell accounts owned by a grandparent or other relative are not reported on the FAFSA, but distributions from them may be counted as student income in the year they are withdrawn.