The Coverdell education savings account (formerly the education IRA) is a tax-advantaged savings plan for post-secondary education. It is modeled on the standard IRA to give tax incentives to persons for saving for education.

Anyone may fund a Coverdell ESA for a single student (beneficiary); however, no more than $2,000 a year may be invested per student regardless of how many separate accounts are created. The contributions can be made until the student's 18th birthday. The contributions are not tax-deductible to the contributor and are subject to phase-out provisions based on the contributor's income; thus, after a certain amount of income, he or she cannot contribute. However, the earnings remain tax-free when they are withdrawn for qualified educational expenses. After the beneficiary attains age 30, withdrawals are no longer tax-free.

Qualified higher education expenses are expenses required for the enrollment or attendance of the designated beneficiary at an eligible educational institution. The following items are qualified higher education expenses:

The cost of room and board is a qualified higher education expense if the designated beneficiary is at least a half-time student at an eligible educational institution. The expense for room and board is limited to one of the following two amounts:

Persons funding the Coverdell education savings account may make investments up to $2,000, unless it is already funded for the year or they are subject to income limitations. Persons whose adjusted gross income (AGI) exceeds federal limitations may make only a partial contribution, determined by the phase-out rules (see IRS Publication 970 for a detailed explanation).

There are penalties for overfunding or taking non-qualified withdrawals (for non-qualified educational expenses). There is a 6% penalty on investments of more than $2,000 deposited into an account if left in past the end of the year. Furthermore, the IRS considers amounts for non-qualified withdrawals or amounts that exceed qualified expenses to be subject to taxation. All such withdrawals are subject to income tax on the amount they earned in the plan as well as a 10% penalty on the excess distributions. In the event of the death or disability of the beneficiary, the 10% penalty will not apply.

If there are any unused funds in the account when the beneficiary reaches age 30, they must be distributed to him or her as a taxable withdrawal. However, rolling these funds over to another Coverdell account for a spouse or qualified family member can preserve their tax-free status. Rollovers may take place without tax consequences if they are rolled over:

One generally cannot take a deduction or tax credit for any educational expense used as the basis for a tax-free withdrawal from a Coverdell ESA. One must weigh the tax consequences of taking a tax-free withdrawal from a Coverdell ESA against other potential tax savings from an educational deduction or tax credit, such as the Hope credit or lifetime learning credit available on IRS Form 1040. The designated beneficiary may waive the tax-free treatment of the withdrawal and elect to pay any tax that would otherwise be owed on the withdrawal. The beneficiary or the beneficiary's parents may then be eligible to claim a Hope credit or lifetime learning credit.

Another consideration is the effect of assets in the Coverdell ESA on eligibility for financial aid. Assets in a Coverdell ESA are considered student assets and will weigh more heavily in computing the contribution from a student's assets than if the same funds were parental assets. This may lower the student's eligibility for financial aid.

The Coverdell ESA has some definite benefits, but it is important to weigh the overall effect on taxes and financial aid against the potential expected family contribution toward higher education.