Coverdell Education Savings Accounts: Covering the Basics
Coverdell ESAs are savings plans described in Section 530 of the Internal Revenue Code (IRC). They're accounts that Congress created to allow you to save now for future educational expenses, whether primary, secondary, or postsecondary, of a designated beneficiary.
You can invest money in Coverdell accounts in a variety of ways: stocks, bonds, money market accounts, certificates of deposit, and so on, although you may not invest in life insurance policies. And I really mean that you can invest; under the Coverdell rules (and unlike Section 529 rules), if you designate yourself the one responsible for all decisions on this particular account (also known as the responsible adult, who must be the parent or legal guardian of the minor child), you keep control of the money and make all the investment decisions for your child's account. Over the years, the investments will hopefully earn significant income through interest, dividends, and capital gains, until the time that the account is closed.
You pay no income tax on the income when it's earned, and as distributions are made from these accounts to your designated beneficiary for qualified educational expenses, the income portion of the distribution is not taxed, either to you or to your student.
A Coverdell ESA must be opened as such, in writing, and you need to designate a beneficiary when you create it; you aren't allowed to take an already existing account and decide that it's now the Coverdell account for your student. Money that you contribute into the account is held by a trustee or a custodian, which must be a bank, mutual fund company, or any other entity that's approved by the Internal Revenue Service (IRS).
Understanding Coverdell Changes
When these accounts were first introduced in 1997 as Education IRA's, they were limited to $500 a year aggregate contribution per student, and distributions could be used to cover only postsecondary expenses. If you were thinking of making a contribution into any plan, you probably would've chosen a Section 529 plan, which had fewer restrictions and allowed you to maintain some contact with your money. Basically, the old Education IRA was a nonstarter for most people because contribution limits were fairly pathetic, and much better ways to save money for college were available.
In the new world of Coverdell (same code section, different name), the aggregate contribution limit has been raised to $2,000 per year, the definition of "qualifying student" has been hugely expanded, and you may now contribute to both a Coverdell account and a Section 529 plan for the same beneficiary in the same year. With all these factors, plus an increase in the income phaseout limitations present under Coverdells but not 529 plans, these accounts can become useful savings tools for many families.