What is an Education IRA?

The term Educational Individual Retirement Account (IRA) has always been a bit of a misnomer. An Education IRA was never intended to be used for retirement, but rather was a place parents could build up funds for their children to draw on when they reached college age. For this reason, the IRS changed the name in 2002. The Education IRA is now called a Coverdell Education Savings Account (ESA). The rules are very similar to an Education IRA with some small but important variations.

There are income limits for those who wish to contribute to an ESA. The modified adjusted gross income of a contributor must not exceed $110,000 US Dollars (USD), or $220,000 USD for those filing jointly. The beneficiary may also contribute to the account up until the age of 18. Teens who have part-time jobs and plan to attend college find this to be a nice feature.

The maximum contribution that parents can make per child under the age of 18 is $2,000 USD per year. This amount was raised from the $500 USD limit that an Education IRA had. Much like a Roth IRA, this contribution is not tax deductible, but the accounts grow tax free until distribution. Even after distribution, they will most likely not be taxed unless the total distributed is more than the tuition and expenses at the approved educational institution. The extra tax on any excess money is 10%.

Contributions can be made into an ESA until tax day of the following year. In other words, if a contributor has not reached their $2,000 USD limit for 2009, they have until 15 April 2010 to complete that contribution. It is important to note that the limit per child is $2,000 USD. Parents and other family members may not establish several accounts in one child's name and contribute any more than $2,000 USD between all of them. A family with two children can contribute $2,000 USD to each child, for a total of $4,000 USD.

The expenses that the ESA can be used on include those accrued at any accredited elementary and secondary school as well as college and vocational institutions. This is another important change from the Education IRA that only allowed the money to be used for post-secondary schools. The funds can be applied to tuition and fees, books, supplies and expenses for room and board.

If the beneficiary has not used the balance of the ESA by the time they reach the age of 30, the money needs to be distributed within 30 days. Any earnings will be taxed 10% at the time of withdrawal. If they choose, they may roll this money into an ESA for another family member to avoid those taxes.