Its name — education savings account or ESA — might sound pretty self-explanatory, but this college planning tool has some must-know rules about eligibility, contribution limits, and use of earnings. What is an education savings account and what can an ESA be used for? Here are the basics.
The basics of education savings accounts
The ESA was originally introduced in 1997 as the Education IRA. In 2001, Congress made some adjustments to the plan and renamed it the Coverdell Education Savings Account after the senator who sponsored the legislation that created it.
The intent of the ESA legislation was for people to be able to set up an account to be used by a beneficiary for qualified education expenses. Although ESA contributions themselves are not tax deductible, ESAs allow money to grow tax deferred and also provides that education savings account withdrawals for qualified education expenses will have no additional taxes.
ESA eligibility and contributions
Unlike some other college savings tools, there are education savings account income limits for contributors. In 2020, a married couple’s gross adjusted income must be under $220,000 (or $110,000 for a single person) to contribute to an ESA. Couples making at least $190,000 (or $95,000 for a solo tax filer) have their maximum contributions reduced proportionately. Contributions are considered gifts under the annual gift tax exclusion, which is $15,000 for individuals in 2020.
Another feature of ESAs: No beneficiary can receive more than $2,000 in ESA contributions per calendar year. This is true even if a beneficiary has multiple ESAs (set up by separate sets of grandparents, for example). Also, no contributions can be made after the beneficiary turns 18, except in special circumstances.
The ESA impact on financial aid
The effect an ESA has on financial aid eligibility depends on the owner of the account. If the ESA is owned by a dependent child or by someone other than the parents (such as a grandparent), then the assets do not count against financial aid eligibility. If the account is owned by a parent, 5.64 percent of the assets are counted against financial aid.
What can an ESA be used for?
One big benefit of ESAs is the wide range of eligible education expenses allowed under the law. ESA funds can be used to pay not only for college tuition but also K-12 education expenses, room and board, books and supplies, tutoring, transportation, computers, and even internet access. There are no taxes on education savings account withdrawals as long as they do not exceed the actual amount of qualified education expenses in a year.
A potential drawback to ESAs is the strict requirement that funds be used within 30 days after the beneficiary turns 30 years old. Otherwise, the assets will be subject to tax on the earnings, as well as a 10 percent penalty tax.