Coverdell Education Savings Accounts (ESAs) were previously known as Education IRAs. They were originally established by the Taxpayer Relief Act of 1997 (P.L. 105-34), and then subsequently expanded by the Economic Growth and Tax Relief Reconciliation Act of 2001, P.L. 107-16 (EGTRRA).

Coverdell accounts are trusts created exclusively for the purpose of paying the qualified education expenses of the designated beneficiary of the trust. They are exempt from federal taxation and have the following characteristics:

• Contribution Amount: Maximum of $2,000 per beneficiary from all sources per year. (There is an exception for contributions resulting from a rollover.)
• Account Ownership: Coverdell accounts may be owned by the student or the student's parent.
• Contribution Age Limit: Contributions may be made until the beneficiary reaches age 18.
• Withdrawal Age Limit: The money must be used by the time the child reaches age 30 or the earnings will be taxed as ordinary income plus a 10% penalty.
• Rollovers: Coverdell accounts may be rolled over to the Coverdell acount of a family member of the previous beneficiary.
• Income Phaseouts: Contributions are phased out for incomes between $95,000 and $110,000 (single filers) or $190,000 and $220,000 (married filing jointly). (These phaseouts may potentially be bypassed by giving money to the child through UGMA/UTMA and having the child contribute to his or her own Coverdell account.)
• Corporations May Contribute: Corporations, including tax-exempt organizations, may contribute to an individual's Coverdell account, regardless of income level.
• Contributions in Cash: Contributions must be in the form of cash. Contributions of stocks, bonds, and other savings vehicles are not permitted.
• Investment Restrictions: No part of trust assets may be invested in life insurance contracts. However, investment options are not otherwise as limited as those offered by section 529 plans.
• Exceptions: There are no age limits for special needs beneficiaries.
• Financial Aid Impact: Treated as an asset of the account owner. If the account owner is the student, this has a high impact on financial aid eligibility. (But note that the Higher Education Reconciliation Act of 2005 added special treatment for Coverdell, Prepaid Tuition and 529 College Savings Plan accounts owned by a dependent student. The impact on need-based aid for dependent students will therefore be minimal.) If the account owner is the parent, this has a low impact on financial aid eligibility. Qualified distributions from a Coverdell account are not counted as income on the FAFSA and thus do not reduce financial aid eligibility.
• Income Tax Implications: Contributions are not deductible on federal or state income tax, but earnings accumulate tax-free. Qualified distributions are exempt from federal income tax. Contributions may be made until the due date of the contributor's tax return (normally April 15 of the following year). Non-qualified withdrawals are taxed as ordinary income at donor's rate and subject to a 10% tax penalty. (Non-qualified distributions remain tax-free in cases of death or disability of the beneficiary.)
• Estate Tax Implications: Contributions are removed from the donor's gross estate but included in the beneficiary's gross estate.
• Qualified Expenses: Primary, secondary, and postsecondary education expenses, including tuition, fees, tutoring, books, supplies, related equipment, room and board, uniforms, transportation and computers.
• Coordination with Section 529 Plans: You can contribute to both a Coverdell account and a section 529 plan in the same year, but there may be gift tax implications if you give more than $13,000 per beneficiary.
• Coordination with Education Tax Credits: You can claim a Hope Scholarship and/or Lifetime Learning tax credit in the same year as you withdraw funds from a Coverdell Account, so long as the credits are claimed using different qualified education expenses than those paid from the Coverdell distribution. You can't use the same expenses to justify two different programs.
• Qualified Education Expenses: In addition to higher education expenses such as tuition and fees, Coverdell Education Savings Accounts can also be used to pay for elementary and secondary education.

Note: Certain provisions of the Economic Growth and Tax Relief Reconciliation Act of 2001 are scheduled to sunset on December 31, 2010. (Note that the EGTRRA improvements made permanent by the Pension Protection Act of 2006 (P.L. 109-280) appear in section 402 of EGTRRA. The improvements relating to Coverdell appear in section 401 of EGTRRA.) These include:

• The addition of elementary and secondary school expenses to the definition of qualified education expenses.
• Increasing the maximum contribution from $500 to $2,000.
• Increases in the income phaseout for married couples.
• Improvements in the coordination with section 529 plans and education tax credits.

Note: Computers are included as a qualified expense for students in elementary and secondary schools even if they are not required by the school. For students enrolled in postsecondary institutions, however, computers are allowed as a qualified expense only if required by the school.

Note: Dear Colleague Letter GEN-04-02 from the US Department of Education clarified the financial aid treatment of Coverdell Education Savings Accounts.