Introduction to education savings accounts

Introduction to education savings accounts

An education savings account (ESA)—sometimes called a Coverdell account—is a savings plan set up and managed by a parent or other adult who is at least 18 years old for the benefit of a minor. When advising on the right account for your clients, keep in mind the specific goals and the advantages of each type of account as well as tax considerations. Schwab encourages you to consult a tax or legal advisor.

Key features of ESAs:

  • Tax benefits—Any account earnings grow tax-deferred, and clients can make tax-free withdrawals when the money is used for qualified education expenses, such as tuition, fees, books, and room and board.
  • Flexibility–This account can be used to pay for qualified education expenses* for college, as well as for kindergarten through 12th grade.
  • Contributions–Clients can contribute to an ESA and a Schwab 529 plan for the same student in the same year.
  • Minimal financial aid impact (depending on investor's financial situation)
  • Investment flexibility—Clients can invest in stocks, bonds, CDs, mutual funds, and more, or select a single-portfolio solution.
  • Account control—Parents, guardians, or other adults who set up the account decide how contributions are invested until the time they transfer the assets to the student.
  • Easy to open an account—No account opening minimum or maintenance fees. Other account fees, fund expenses, and brokerage commissions may apply.
  • Available account features—ESAs are eligible for certain covered and protective option strategies, ACH (Schwab MoneyLink®), householding
    Withdrawal power financial advisor (WPFA), and Withdrawal power financial advisor-custody (WPFA-C).

Key information related to ESAs:

  • The custodian established on the account retains authority throughout the life of the account. Authority is not automatically passed to the student at the age of 18 but can be allocated at the discretion of the custodian.
  • Your client can authorize your firm to debit management fees from the account. Before using this feature, please examine the tax consequences.
  • The earnings portion of a nonqualified withdrawal is subject to federal and state income tax and a 10% penalty.
  • When the student reaches age 30, all unused funds must be distributed to them as a taxable withdrawal. However, if the funds are rolled over to a qualified family member of the student, the tax-free status of the account can be preserved.
  • The maximum contribution is $2,000 per year, per student, and is subject to income limits until the student's 18th birthday.

All nonqualified withdrawals are subject to federal and state income tax and a 10% penalty. State tax treatment of earnings may vary.
Contributions over the legal maximum of $2,000 per year are subject to an additional 6% tax for each year the excess remains in the account. State laws may differ from federal tax law. Clients should consult a tax advisor on their own situation.

For information regarding contributions, tax considerations, beneficiaries, and more, refer to the following:

Contributions

  • An ESA is funded with nondeductible (after-tax) contributions, with an aggregate maximum of $2,000 per student, per year, until the child's 18th birthday (subject to income phase-out).
  • Special-needs students are exempt from the prohibition against contributions after their 18th birthday.
  • Contributions must be made by the standard tax-filing deadline of April 18 following the end of the tax year, with no extensions.
  • Contributions are invested at the account holder's discretion.
  • Your client may direct deposit all or a portion of their federal tax refunds into an ESA. See How to set up direct deposits for information and eligibility requirements.
  • Contributions from corporations, tax-exempt organizations, and other entities are also permitted.
  • See the following table for income and contribution limits:
Modified adjusted gross income Maximum contribution per year
Single filers Married filers
$95,000 and under $190,000 and under $2,000
$96,500 $193,000 $1,800
$98,000 $196,000 $1,600
$99,500 $199,000 $1,400
$101,000 $202,000 $1,200
$104,000 $208,000 $800
$105,500 $211,000 $600
$107,000 $214,000 $400
$108,500 $217,000 $200
$110,000 and over $220,000 and over $0

Tax considerations

  • Contributions are not tax-deductible.
  • Any earnings on contributions grow tax-deferred and can be withdrawn tax-free for qualifying expenses.
  • The account must be established by the tax-filing deadline (April 18), with no extensions to qualify for that tax year.
  • Qualified withdrawals for education expenses for elementary school, secondary school, and college (public and private) are tax-free.
  • Contributions are reported on IRS Form 5498-ESA for the calendar year designated.
  • Withdrawal of earnings for nonqualified education expenses are taxable and may be subject to a 10% penalty.
  • Contributions over $2,000 per year must be removed before June 1 of the following year. If these excess contributions are not removed, the student is subject to a 6% additional tax for each year the excess remains in the account.

Remaining assets

  • When the designated student reaches age 30, all remaining assets in an ESA must be distributed to him or her.
  • The earnings portion of this distribution is normally taxable and subject to a 10% penalty.
  • If the designated minor does not use the funds for higher education by age 30, the funds may be passed on to another direct family member under the age of 30 (i.e., siblings, nieces, nephews) for payment of their higher education expenses.
  • When the distributed funds are rolled over within 60 days to an ESA for a qualified family member of the designated beneficiary, the account's tax-free status is preserved. Only one rollover per year is permitted.

Beneficiaries

  • The account owner may change the designated beneficiary from one child to another member of that child's family at any time.
  • Members of the family include children and their descendants, stepchildren and their descendants, siblings and their children, parents and grandparents, stepparents, and spouses of all family members listed previously.
  • Upon the death of the designated student, his or her estate is considered the successor, unless a successor was named by the account owner while the original designated student was alive.
  • To name a successor beneficiary other than the minor's estate, use the ESA Designated Beneficiary/Authorized Person LOA Form on the Forms library page of Schwab Advisor Center®; the successor must be a qualified member of the current designated student's family.

Distributions—qualifying withdrawals

  • Qualified education expenses include tuition, fees, books, supplies, room, and board, for elementary, secondary, or post-secondary education at an eligible educational institution.
  • Other qualified expenses are academic tutoring, purchase of computer technology or equipment, internet access, expenses for uniforms, transportation, and supplementary items and services, such as extended day programs as required or provided by the school.
  • Qualified distributions may be made for college students attending an 'eligible educational institution' at least half-time.
  • The designated beneficiary may claim the American opportunity credit or the lifetime learning credit on his or her federal income tax return in the same taxable year, if the distribution(s) does not cover the same expenses.

Distributions—non-qualifying withdrawals

  • If the withdraw amount from the ESA exceeds the qualified education expenses for the same year, or if the distributions are not used for qualifying education expenses, a portion of the distributions will be taxable.
  • The amount exceeding the qualified education expenses is taxable pro rata, based on the earnings and the basis in the account.
  • In most cases of a nonqualified distribution, the taxable portion of the ESA distribution is also subject to an additional 10% penalty tax.
  • Withdrawals from the ESA are not subject to federal income tax withholding.

    Note: It's assumed when a withdrawal is made that both earnings and contributions are withdrawn together.

Exception to penalty

  • Distributions are made payable to a designated death beneficiary of the ESA or to the estate of the designated beneficiary.
  • Distributions are made payable to the designated beneficiary if the designated beneficiary is disabled.
  • If the designated beneficiary received a qualified scholarship, educational assistance allowance, or an excludable payment exception.
  • If it is a return of an excess contribution before the due date of the beneficiary's tax return. See IRS publication 970 for more information.

Requesting distributions

  • Complete and submit the ESA Distribution Form.
  • Send the signed form to your Schwab service team via a Schwab Advisor Center service request.
  • Verbal withdrawal requests are also acceptable if the client wants a check made payable to the account registration name and address. Third party distributions may be requested by submitting the ESA Distribution Form.

Review a side-by-side comparison of the goals and advantages of college savings investing accounts and their tax considerations: College savings accounts goals and advantages.

Do ESAs have any impact on a beneficiary's financial aid eligibility?
Yes. ESAs are likely to have a minimal impact on financial aid eligibility, depending on investor's financial situation. A parent-owned ESA is considered a parental asset for purposes of calculating financial aid eligibility. However, only 5.6% of parental assets and income are reflected in the calculation.

What is the contribution limit?
Contributions are limited to $2,000 per year until the beneficiary's 18th birthday. Contributions are not tax-deductible, and income limits apply that may reduce this amount.

Are there withdrawal penalties for this account?
Withdrawals of earnings for nonqualified expenses may be subject to a 10% federal penalty and are considered taxable income. Contributions over the legal maximum of $2,000 are subject to an additional 6% excise tax for each year the excess remains in the account.

Can a student have more than one ESA?
Schwab will only set up a single ESA for each student. Your client's child may have other ESAs at other companies, but total contributions to all ESAs are limited to the $2,000 annual limit.

What if my client opens an ESA, but decides not to go to college?
If the beneficiary of an ESA decides not to go to college or doesn't need all the funds, the ESA may be transferred to another member of the child's family.

Can my client roll over funds from a traditional or Roth IRA into an ESA?
No. Rollovers into an ESA are not allowed.

How to add and update account beneficiaries
How to open an education savings account
How to set up direct deposits
Introduction to 529 College Savings Plans
Introduction to cash options and investments
Introduction to custodial accounts
Introduction to householding

Leverage the College Savings Calculator to help you estimate the annual deposits your client may need to make.

For more information, see: