Chapter 04: What is an Education Savings Account (ESA)?

In this series, we’ve briefly touched on the different types of college savings accounts, one of which is the Coverdell education savings account or ESA. In Chapter 4, we’ll go into more depth about this type of account, answering questions like “what is an ESA?” and “what are the benefits of an ESA?”.

A Coverdell education savings account (ESA) is a type of investment account that allows you to invest money toward education expenses for your child. These accounts are different from traditional investment accounts because they’re tax-advantaged and specifically designed for education.

If you’re considering a Coverdell education savings account, this chapter can help you understand how ESAs work and decide if an ESA is the right option for you when it comes to saving for college. Keep reading or use the links below to go straight to the section that best answers your question.

• What Is an ESA & How Does a Coverdell ESA Work?
• What Are the Benefits of an ESA?
• What Are the Disadvantages?
• Coverdell ESA vs 529 Plans
• In Conclusion: Is an Education Savings Account Right for You?

What Is an ESA & How Does a Coverdell ESA Work? 

What is an ESA meant for? A Coverdell ESA is a type of investment account that’s designed just for education purposes. While there are some key differences between ESAs and other types of investment accounts, they work similarly. You contribute a certain amount of money and that account increases in value with time. 

The thing that makes ESAs different from other types of investment accounts is that your earnings are tax-free as long as they’re used for qualifying education expenses. This is similar to how a 529 account works—which we’ll cover in Chapter 5—but there are significant differences between 529 accounts and ESAs. Essentially, these education-based investment accounts provide greater investment earnings as long as those earnings are used to pay for qualifying expenses.

While budgeting and making small changes in your life can help you save for college for your child, an education savings account can get more out of your investment. That being said, some people use traditional investment accounts to save for their children’s college expenses because there are limitations with ESAs. 

Choosing the right way to invest is an important step in saving for college and we’re here to help you consider all the factors to make the best choice for your circumstances. 

What Are the Benefits of an ESA?

There are a lot of benefits to using an ESA when it comes to saving for college. ESAs offer a relatively simple solution for parents who want to contribute money to an investment account to fund their child’s college education. 

Here are some of the most notable benefits of an ESA.

Tax-Advantaged

Arguably the biggest advantage of ESAs is the fact that they’re tax-advantaged, which means you don’t have to worry about losing a significant portion of your investment earnings when your child withdraws their money.

This is similar to the way that a 529 college savings plan works. Keep in mind that ESA investment earnings are only tax-free if you use the funds for qualifying education expenses. If the money isn’t used for qualifying expenses, it will be taxed at your regular rate.

Investment Flexibility

While a 529 plan allows you to invest in a static selection of options, you’re somewhat limited in terms of what you can invest in. With ESAs, you can invest in a broader range of securities, including:

• Stocks
• Bonds
• Mutual funds

This flexibility can be an advantage if you are strategic or hire a financial advisor to help you decide on the best investments. We’ll talk more about 529 plans and how they work in the next chapter.

Allows for Financial Aid Eligibility

Certain assets can have a major effect on your child’s financial aid eligibility, but that’s not the case with ESAs and 529 plans. While an education savings account will have some effect on your child’s financial aid eligibility (i.e. the amount of money they get), it won’t cause them to lose out on a significant portion of their financial aid. 

This makes ESAs more desirable for saving and paying for college for some people, especially when compared to UGMA and UTMA accounts which we’ll discuss in more detail in Chapter 7.

Versatility

You might think of educational savings accounts as college funds, but that money can actually be used for your child’s K-12 education as well. If you get an early start on things, you can use an ESA to help fund private schooling and other K-12 education expenses in addition to college. As long as the education expenses you’re paying for are considered qualifying expenses, you can use ESA funds for them.

What Are the Disadvantages?

While there are several advantages to making a financial plan that includes an education savings account, it’s important to consider the disadvantages as well. Here are some of the things to think about before investing in an ESA.

Income Limits

For starters, ESAs have income limits that may make them a less desirable option for some people. As a matter of fact, you can’t invest in an ESA if you make more than $110,000 if you’re filing single, or $220,000 if you’re married filing jointly. Even if you’re just over the limit, you can’t contribute to an ESA to save money for your child’s college.

Contribution Limits

Another potential disadvantage in terms of limits is the contribution limit that exists with ESAs. Many investment accounts have contribution limits because of the tax benefits they offer, that way investors can’t take advantage of too much tax-free income. With ESAs, you’re only able to contribute a maximum of $2,000 per child, per year, so growth may be a little slow. 

This can be especially frustrating if you have the means to invest that amount several times over, because you could earn a lot more with a higher contribution limit.

Age Limits

Speaking of limits, there’s also an age limit for Coverdell education savings accounts. The rule is that you’re not allowed to contribute to an ESA fund for an individual once they turn 18, which means you may have to stop contributing before your child goes to college. This can limit the amount of money parents are able to invest, which can be difficult with the current cost of living and college expenses.

Not Tax-Deductible

Another potential disadvantage when it comes to education savings accounts is that they’re not tax-deductible. This isn’t a huge downside, but it’s something to consider when you’re choosing between an ESA vs a 529 plan because some states may offer tax breaks if you invest in a 529 plan. At the very least, you may want to talk to a financial advisor to learn more about how taxes work with each of these investments.

Coverdell ESA vs. 529 Plans

When it comes to investing for college, a Coverdell ESA and 529 plan are two of the most common types of investment accounts. These investment accounts are designed specifically for investing in your child’s education, so they can be a good way for some families to save for college. That being said, there are some key differences between the two. So, what is a Coverdell education savings account vs a 529 plan, and which is right for you?

Similarities

To start, there are a lot of similarities between ESAs and 529 plans. 

• Tax-Advantages: Both of these accounts are tax-advantaged, which means you don’t have to pay any taxes when the money is withdrawn and used for education. 
• Financial Aid: Unlike some other assets, both ESAs and 529 plans have a minor effect on your financial aid eligibility, so you don’t have to worry about your child losing out on a bunch of financial aid as a result of an ESA. 
• K-12 Educational Expenses: ESAs and 529 plans can both be used to pay for K-12 education expenses in addition to college.

Differences

Of course, there are also some key differences between a Coverdell ESA and a 529 plan. One of the biggest differences between an ESA and a 529 plan is the fact that ESAs come with certain restrictions. 

• Contribution Limits:You can only contribute up to $2,000 per child, per year with an ESA, and you can only contribute to your child’s ESA until they turn 18. 
• Income Limits: Not only that, but there’s also an income limit, so you can’t contribute to an ESA if you make more than $110,000 filing single or $220,000 married filing jointly. A 529 plan, on the other hand, has no income, age, or contribution limits. 
• Tax Deductions: Contributing to a 529 plan may make you eligible for tax deductions in certain states, while ESAs don’t come with those potential tax breaks.

In Conclusion: Is an Education Savings Account Right for You?

It’s not easy managing money at a young age and paying for college, so starting an investment account to help your child save for college can be one way to minimize the financial barrier to higher education. While it has its benefits, a Coverdell education savings account is one of a handful of education-based investment accounts you might consider. You may find that a 529 plan may be a better fit based on priorities.

In the next chapter, we’ll take a closer look at 529 plans to help you decide what type of education investment account is right for you.