How Does a Coverdell ESA Differ From a Traditional IRA?

IRAs and ESAs can both pay for books and supplies.

IRAs and ESAs can both pay for books and supplies.

Traditional individual retirement accounts and Coverdell education savings accounts are both tax-advantaged. You can also use both to help pay college expenses. Above and beyond those similarities, though, they are very different types of accounts with very different sets of rules, benefits and drawbacks. Understanding them is the first step to choosing the right one for you.

Traditional IRAs

A traditional IRA is designed as a retirement savings account. Every year, the Internal Revenue Service lets you put a certain amount of money in and deduct the contributions you make. When you reach the predetermined retirement age of 59 1/2, you can pull money out of your IRA without penalty. Everything that comes out, though, is subject to income tax. The IRS also allows early withdrawals without penalties for certain expenses, including educational expenses.

Coverdell ESAs

A Coverdell education savings account is a special account that you can set up to fund higher education expenses. It needs to be created with a beneficiary that is under 18, so when you're already an adult, you can't create one for yourself. The money that you put into a Coverdell account is after-tax, but everything that comes out of it that gets used to pay for college expenses is tax-free. Like an IRA, the IRS caps how much you can put into a Coverdell account. Finally, if you have money left in the Coverdell account, you can transfer it to a family member or pull it out, but a non-educational distribution gets hit with tax and a 10 percent penalty.

Allowed Expenses

Both accounts can be used to pay for tuition, fees and supplies. They can also be used to pay for qualified room and board. IRA money can be withdrawn penalty-free only for post-secondary education, though Coverdell money can also be used for private primary and secondary schools.

Coverdell vs. IRA

The different nature of the two accounts means that they serve different purposes. Money put into an IRA can be used for more things, and you can put more in. Coverdell accounts, on the other hand, are more flexible tools for educational savings. The ability to pull out earnings tax-free also means that you can use everything that comes out of the account, while IRA distributions get reduced by the taxes you owe on them.

 

About the Author

Steve Lander has been a writer since 1996, with experience in the fields of financial services, real estate and technology. His work has appeared in trade publications such as the "Minnesota Real Estate Journal" and "Minnesota Multi-Housing Association Advocate." Lander holds a Bachelor of Arts in political science from Columbia University.

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