If your child does it right, she won’t have to pay any tax at all on money she withdraws from the Coverdell Education Savings Account (ESA) you set up for her – but she’ll be hit with regular income tax and hefty penalties if she doesn’t follow the guidelines. Here’s what you need to know.

 

ESAs Are Tax-Advantaged College Savings Plans

If you want to save for your child’s education and she’s less than 18 years old, you’ll receive tax benefits by using a Coverdell Education Savings Account, also simply called Education Savings Account. You must pay state and federal income tax on the money you deposit, but all earnings on the principal are tax-free from that time on. For example, you won’t get a tax deduction or credit for the money if you deposit $5,000 into an ESA, but the fund might be worth $10,000 in a decade if you invest the ESA money in mutual funds that earn a moderate return. Your child will not owe tax on the $5,000 gain when she takes a distribution if she follows the ESA distribution rules. 

Your child must pay tax on the earnings as well as a 10-percent penalty, however, if the rules are not followed. Some income limitations apply to contributions, so check with your financial adviser before leaping in.

 

Qualifying Schools

The government gives ESAs tax advantages to encourage people to save for their kids’ educations, but not just any school or training program will do. Your student must use the money to attend a qualifying school. “One big difference between ESAs and other tax-advantaged school savings plans involves the definition of qualifying schools,” says San Francisco financial planner Jim McHale. “You can use ESA money for elementary and high school expenses as well as college.”

Does your school qualify? The IRS defines a qualifying postsecondary school as “any college, university, vocational school, or other postsecondary educational institution eligible to participate in a student aid program administered by the U.S. Department of Education.” Most accredited institutions are included. Eligible elementary or secondary schools include those offering kindergarten through grade 12 educations, whether they’re public, private or religious.

 

Qualifying Expenses

Tuition, books, supplies and equipment that a school requires a student to own are qualified expenses for an ESA. If your student is enrolled in college at least part time, she can also use the ESA money for room and board. 

You can use ESA money for room and board, uniforms or transportation for your elementary or high school students if the expenditures are required by the school, such as a boarding school. Computer equipment and Internet access may also be considered qualifying expenses for elementary or high school students if they’re used for school purposes.

 

Other Restrictions With Tax Implications

The maximum amount you can contribute to an ESA for any one year is $2,000, and the maximum total amount that can be contributed to an ESA for a student in any one year is $2,000. This means that if you start an ESA for little Susie, then her grandparents start one and an uncle starts one, too, the total contributions for 2015 must be $2,000 or less. 

What happens if you contribute too much? The beneficiary will owe a 6-percent excise tax on excess contributions to be paid at the end of the year.