The Rules for an Education IRA

An education IRA is a tax-advantaged savings account designed to help parents and students accumulate money for education costs. Now known as Coverdell Education Savings Accounts, an education IRA allows savings to earn tax-free money. Under Coverdell ESA rules, withdrawals are tax-exempt when they're withdrawn, provided the amount of the withdrawal isn't more than qualified education expenses.

Coverdell Contribution Rules

The education IRA or Coverdell ESA must have a designated beneficiary named at the time the account is opened. Contributions of up to $2,000 a year can be made to the account until the beneficiary turns 18. The age limit is waived for special needs students. The contributions are not tax deductible. Earnings aren't taxable while they remain in the ESA. The money is tax-exempt when it's withdrawn as long as the annual distributions don't exceed qualified education expenses.

Individuals or organization can add money to a Coverdell ESA as long as the aggregate contributions from all parties don't exceed the $2,000 limit. The Internal Revenue Service limits individual contributions to taxpayers with modified adjusted gross incomes of $220,000 if they're filing joint returns. The income limit for those with other filing statuses is $110,000. (Reference 2)

Qualified Education Expenses

You can use Coverdell ESA money to pay costs related to attending primary and secondary schools, as well as colleges and vocational schools. Postsecondary schools must be eligible to receive federal financial aid. If you use ESA funds for high school or grammar school, the institution must meet state requirements. You can withdraw Coverdell funds up to the amount of qualified education expenses that remain after subtracting amounts received as tax-exempt student aid. Qualified expenses include:

  • Tuition
  • Fees
  • Books, equipment and supplies
  • Services required as a special needs student
  • Room and board if required and provided by the school
  • Required transportation and uniforms for a primary or secondary school

When Distributions are Taxable

Excess Distributions: If you take out more than the amount of qualified education expenses, part of the excess is taxable. Contributed funds aren't subject to taxes when they're distributed because the money wasn't tax-deductible when you put it in the ESA. For example, you might have withdrawn $500 more than necessary one year. If 40 percent of the money in the account consists of investment earnings, 40 percent or $200 of the excess distribution counts as taxable income. The IRS normally adds a 10-percent penalty to the taxable portion. The penalty doesn't apply if the beneficiary becomes disabled, dies or if the extra distribution was due to the receipt of nontaxable scholarship or grant money.

Leftover Funds: Unless a beneficiary is a special needs student, funds that remain in the account when she turns 30 years old must be withdrawn. Taxes plus the 10 percent penalty must be paid on the earnings portion of the money. You can avoid taxes and penalties by designating another family member under age 30 as the new beneficiary.