How Does a Coverdell Education Savings Account Work?

As with preparing for any financial goal, strategy is key. When you’re planning how to save for college, you’ve got a variety of custodial accounts to choose from. You’re probably familiar with the most common college savings option—the 529 plan—but there are other college savings options that can provide different benefits. A Coverdell education savings account (ESA) is one of these options.  

Like a 529 plan, a Coverdell education savings account offers tax benefits as you save for college, but there are some key differences between the two to be aware of. We’ll share the basics about what a Coverdell ESA is and how it works and show you how it compares to a 529 plan so you can decide whether it might be a savings option you want to take advantage of.  

What is a Coverdell education savings account? 

A Coverdell education savings account, or ESA savings account, is a type of custodial account you can open for a minor to save for college. Like other college savings options, it has certain tax benefits. Any contributions you make to a Coverdell account can grow tax-deferred and be withdrawn income tax-free as long as funds are used for qualified education expenses.  

How does a Coverdell education savings account work? 

When you open a Coverdell ESA, you’ll open it in your child’s name. At that point, anyone is able to contribute to the account as long as contributions stay within the contribution limits. Once you set up the Coverdell savings account, you’ll select investments that will help the money in the account grow tax-deferred. These can include many types of investments, like individual stocks, bonds, exchange-traded funds, mutual funds or real estate investments. 

You’re able to withdraw money at any time from a Coverdell account to cover qualified education expenses; and as long as you use the money for qualified expenses, you won’t have to pay tax on it. The nice thing about a Coverdell ESA is that it’s a bit more flexible than a 529 plan in terms of what you’re able to use the money for.  

What can a Coverdell ESA be used for? 

With a Coverdell savings account, qualified education expenses can include the following:  

• Primary or secondary school expenses (including tuition, uniforms, transportation or computer equipment) 

• Room and board  

• Higher-education tuition 

• Books and equipment 

• Special-needs services or academic tutoring  

Any funds you withdraw that are not used for qualified education expenses are subject to income tax as well as a 10 percent penalty, so it’s really in your best interest to make sure these funds go toward qualified expenses. (If you don’t need all of the money for education expenses, or if your child decides not to go to college, you do have some options for accessing the money.)  

What happens to a Coverdell if the child doesn’t go to college? 

A Coverdell account must be liquidated by the time the beneficiary turns 30 (unless special needs are involved). So, if your child decides not to go to college, you could simply withdraw the funds from the account and pay income taxes on the appreciation.  

If you have additional children, another option is to change the name of the beneficiary on the account to a younger sibling, which you can do once per year. You also have the option of rolling funds in a Coverdell ESA into another ESA or 529 plan.  

Who is eligible for a Coverdell account?  

Legal adults whose income falls within a certain range can open a Coverdell account on behalf of a minor. In 2024, a family with an adjusted gross income below $190,000 or a single taxpayer with an adjusted gross income below $95,000 is eligible to open and contribute to a Coverdell account up to the annual contribution limit.  

Though the parents don’t necessarily need to be the ones to open an account for the child, who the account owner is could impact how much the child is able to take out in student loans, so it’s something to consider. Once the account is established, anyone is able to contribute to the account as long as contributions stay within the annual contribution limits.  

2023 Coverdell ESA contribution limits 

Like many other tax-advantaged savings accounts, Congress limits how much you’re able to contribute to a Coverdell savings account each year. These limits apply to the account beneficiary—not to the contributor. So, a beneficiary can receive only $2,000 in contributions to any Coverdell accounts each year, regardless of who contributes.  

Your modified adjusted gross income (MAGI) also impacts how much you’re individually able to contribute. If your MAGI falls within the income limits for opening an account (under $190,000 for a married couple filing jointly or $95,000 for an individual), you can contribute up to the full limit each year. If you make more than this, you’re able to contribute a reduced amount, but if you make over $220,000 (married filing jointly) or $110,000 (single), you are not able to contribute to a Coverdell savings account. 

Once the beneficiary of the account turns 18, you’re no longer able to contribute to the account (however, if the beneficiary has special needs, you may be able to contribute for a bit longer).   

What’s the difference between a 529 and a Coverdell ESA?  

As with saving for retirement, diversifying your college savings can be a great way to make sure you make the most of each tax-advantaged vehicle and spread out your risk. So, you could consider opening both a Coverdell ESA and a 529. 

There are some substantial differences between the two accounts to be aware of, however, including these:  

Age requirements 

Funds in a Coverdell savings account must be used by the time the beneficiary turns 30; otherwise, you’ll be subject to tax, penalties and possible fees upon withdrawal. With a 529, there are no restrictions on how old the beneficiary must be to use the funds.  

If you’re left with unused funds in either a Coverdell account or a 529, you could change the name of the beneficiary to cover educational expenses for another child. However, with a 529 plan, you may be able to roll unused funds (up to $6,500 per year to a total of $35,000) into the beneficiary’s Roth IRA as long as you’ve had the plan for at least 15 years.  

Contribution limits 

Both Coverdell accounts and 529 plans have contribution limits, but the contribution limits for a 529 plan vary by state, and they’re generally much higher than Coverdell contribution limits. The annual Coverdell contribution limit is $2,000 per year, whereas the annual contribution limits for a 529 plan can range from $200,000 to $500,000 per year depending on the state plan rules (though with a 529 plan, you will need to consider the gift tax consequences for large gifts).  

Eligible expenses 

Though both accounts can cover education expenses, Coverdell accounts can typically be more helpful in covering K-12 expenses (including equipment, tutoring and other needs) than a 529 plan can. To pay for qualifying elementary and secondary school expenses, you can withdraw only up to $10,000 per year from a 529 plan (depending on the state). A Coverdell ESA doesn’t have any limit to how much you can withdraw to cover these expenses. 

A 529 plan, though, can cover some expenses that a Coverdell savings account can’t. You also may now be eligible to use up to $10,000 per year from a 529 to repay student loans. (Funds in a Coverdell ESA cannot be used to repay student loans.)  

Investments 

One of the biggest differences between a 529 plan and a Coverdell savings account is the range of investments available to you. With a 529, you’re generally more limited as to which funds you’re able to invest in, but you typically are able to choose from investment options in your given plan. But with a Coverdell ESA, you’ll often have a full range of investments—stocks, bonds, mutual funds or exchange-traded funds—to direct your dollars to.  

How to open a Coverdell education savings account  

Before opening a new savings account, it’s a good idea to take stock of what you have and understand how a new account would work with the other accounts you’re already contributing to. A financial advisor can be really helpful with this exercise.  

A Northwestern Mutual financial advisor can help you look at your savings goals—including paying for college—and recommend the best path forward based on your personal situation.  An advisor can also help you see the big picture, keeping other financial goals—like saving for retirement—in mind, too. However you choose to save, it’s helpful to plan ahead and be strategic with where you put your money to make sure you get the most out of your savings.