What Is an Education IRA?

College can be expensive. If you have children who plan on enrolling, finding ways to cover some costs has probably crossed your mind. An education IRA is a type of individual retirement account that allows you to get a head start and save for college expenses while your kids are still young. Take a look at the advantages that come with opening an account and how you can use the money to cut costs. 

What Is an Education Savings Account?

An education IRA, or a Coverdell ESA, is more formally known as a Coverdell Education Savings Account. Its purpose is to help you save for your children's college education while you also receive tax breaks. Since 2002, it has been permissible to also spend the account money on certain education expenses for grades K-12. 

Any contributions you make toward your account aren't tax-deductible, which means you have to pay income tax on the money before it's invested. However, the interest earned on your account isn't taxed, so you don't have to pay taxes on the money you withdraw to use toward qualified education expenses. Examples of these expenses include:

• Basic room and board costs 
• School equipment and supplies
• Books
• Tuition
• Fees

The money you invest in the IRA grows through compound interest. If you start adding funds to the account while your kids are young, the amount grows over time and is potentially a big help at a time when your kids need that money the most. 

Advantages of an Education IRA

People may choose to invest in an education IRA for a few reasons. These include:

• Tax-free withdrawals if used for qualified education expenses
• No taxes on the money your account earns
• No gift tax payments on contributions to the account
• It's possible to make contributions to an education IRA and a 529 plan at the same time with some limitations

Contribution Limits and Regulations

A few rules apply to how much you can contribute to your education IRA. Each child has a contribution limit of $2,000 per year. You also have to make any contributions before the due date of your tax return. Relatives, trusts and corporations can make contributions as well, but the total amount from all sources can't exceed $2,000.

However, no limitations exist regarding the number of education IRAs you can open for each child. By opening multiple accounts, you can save more money by adding up to the maximum amount of funds to each of them. 

To sum this up, limitations apply to the total contributions to each account, not the number of accounts you open. 

Additional rules for education IRAs include:

• If your child doesn't go to college, the funds can still be distributed, but taxes may apply.
  
  
• The dollar amount of funds in the education IRA is one of the factors colleges and universities use to determine financial aid.
  
  
• For participation in an education IRA, your gross annual income must fall below $110,000 for an individual or $220,000 for a married couple.
  
  
• Each account may be charged a maintenance fee. 
  
  
• Once the beneficiary of an account turns 30, they may be charged a penalty or fee if any money remains in the account.
  
  
• After your child turns 18, you can no longer contribute to the account.
  
  
• Withdrawals made for qualified education expenses are usually tax-free.
  
  
• Beneficiaries are required to pay taxes on a portion of the account's earnings for withdrawals in excess of education expenses.   
  
  
• It may be possible to transfer one child's education IRA to the education IRA of another family member, such as a sibling. 

What Is the Difference Between an Education IRA and a 529 Plan?

Another way to save money for future education expenses while earning a tax break is a 529 plan. This plan has similar tax breaks to those of an education IRA. In both cases, you don't have to worry about tax payments while the account is gathering interest. Withdrawals are also tax-free if the funds are used for qualified education expenses.

However, there are key differences between a 529 plan and an education IRA. 

Income Limits

529 plans don't put income limitations on your account as education IRAs do. Even if you earn more than $110,000 a year for an individual or $220,000 for a couple, you can open and keep a 529 plan. 

Dual Contributions

It's possible to contribute to a 529 plan and an education IRA for the same child in the same year. However, your combined contributions can't exceed the annual gift tax exclusion amount.

Primary and Secondary School Costs

If you're using the savings in a 529 plan for your child's elementary or secondary education, the funds can only be spent on tuition. With an education IRA, you can use the funds for qualified education expenses outside of tuition. 

Additional Information About Education IRAs

How Do You Withdraw Money From an Education IRA?

You'll need to fill out a Coverdell ESA distribution request form from the financial institution that has the account. After you submit the form, you'll have access to the funds to use toward qualified education expenses. 

Can This Money Be Used To Buy a House?

The money you withdraw from an education IRA must be used toward qualified education expenses. Even if your child is enrolled in an educational program and the house is in their name, they can't use the money for mortgage payments because it isn't considered a qualified education expense.

These payments go toward loan payments, not housing costs. However, the funds can be used to pay for room and board. 

What Happens to the Money if It Isn't Used?

An education IRA requires the beneficiary to withdraw all funds from the account before turning 30. If funds are left over, a tax penalty may be imposed and income taxes may be due on the amount left in the account.