A Coverdell education savings account (ESA)—often referred to simply as a Coverdell—is a tax-advantaged investment account that families can use to save for their child's elementary, secondary, or college education expenses. This report provides an overview of the mechanics of Coverdells, including a summary of the key parameters of Coverdells. The report also examines the specific tax advantages of these plans. For an overview of all tax benefits for higher education, see CRS Report R41967, Higher Education Tax Benefits: Brief Overview and Budgetary Effects , by [author name scrubbed]. A Coverdell education savings account (ESA)—often referred to simply as a Coverdell—is a tax-advantaged investment account that can be used to pay for both higher-education expenses and elementary and secondary school expenses. The specific tax advantage of a Coverdell is that distributions (i.e., withdrawals) from this account are tax-free, if they are used to pay for qualified education expenses. If the distribution is used to pay for nonqualified expenses, a portion of the distribution is taxable and may also be subject to a 10% penalty. (An overview of qualified and nonqualified expenses is provided later in this report.) Generally, a contributor, often a parent, makes a contribution to a Coverdell for a designated beneficiary, often their child. Contributors can open a Coverdell at many banks, brokerage firms, or mutual fund companies. Since Coverdells are established for minors, a "responsible individual" is named to the account, generally the beneficiary's legal guardian. This responsible individual may also be a contributor to the account. While a contributor selects the initial investments for a beneficiary when they open the account, the responsible individual (if they differ from the contributor) makes investment and withdrawal decisions after the account is established. Contributions to a Coverdell must be made in cash using after-tax dollars. This means contributions to Coverdells are not tax deductible to the contributor. Contributions to a Coverdell are prohibited once a beneficiary reaches 18, and the balance of the account must be liquidated when the beneficiary turns 30. However, these age limitations do not apply to special-needs beneficiaries. In addition, the total amount that can be contributed to all Coverdells for a given beneficiary is limited to $2,000 per year. Any contributor can contribute up to $2,000 into a beneficiary's Coverdell, as long as the contributor's income is below certain limits. Specifically, as the contributor's income exceeds $95,000 ($190,000 for married joint filers), the maximum amount the contributor can donate ($2,000) is reduced. When the contributor's income exceeds $110,000 ($220,000 for married joint filers), a contributor is prohibited from funding a Coverdell. (None of these amounts are adjusted annually for inflation.) Several parameters of Coverdells were temporarily modified by the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA; P.L. 107-16 ) and were initially scheduled to expire at the end of 2010. At the end of 2010, these changes were extended for 2011 and 2012 by the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 ( P.L. 111-312 ). Subsequently, the American Taxpayer Relief Act of 2012 ( P.L. 112-240 ; ATRA) made these modifications permanent beginning in 2013. Two modifications which received recent attention include an increase in the annual contribution limits and an expansion of the definition of qualified expenses. Specifically, EGTRRA increased the annual contribution limit from $500 to $2,000 per beneficiary and allowed elementary and secondary expenses to be considered qualified education expenses. Upon enactment of ATRA, these and other changes were made permanent. Hence, under current law, in 2018 the annual contribution limit will remain $2,000 per beneficiary per year from all contributors and qualified expenses will include elementary and secondary expenses. The current parameters of Coverdells are outlined in Table 1 ("Parameter in Effect"). For comparison, Table 1 summarizes the parameter prior to its modification by EGTRRA ("Parameter Prior to 2001 EGTRRA Modification"). As previously mentioned, the specific tax advantage of Coverdells is that withdrawals from these plans are excludable from gross income, and hence not subject to income taxation, if they are used to pay for specific education expenses incurred in a given year. These expenses are referred to as adjusted qualified education expenses (AQEE-see shaded text box). Any amount withdrawn from a Coverdell account which does not go toward these expenses is subject to income taxation and may be subject to an additional 10% penalty tax. Logically, a taxpayer who receives a Coverdell distribution (the beneficiary or the beneficiary's guardian) would seek to minimize their income tax liability by withdrawing just enough money from their Coverdell to cover AQEE and no more. However, especially when Coverdells are used for higher education expenses, this is not as straightforward as it may seem due to a variety of factors, including the availability of other education tax benefits and student aid. In order to understand the complex decisions taxpayers must consider when determining the amount of money they should withdraw from a Coverdell, this section details the income tax treatment of Coverdell distributions, including the definition of AQEE, when Coverdell distributions may be taxable, and the interaction of Coverdell distributions with other education tax benefits. (An overview of basic gift tax rules is also included.) Contributors to Coverdells receive no federal income tax benefit from funding a Coverdell. Instead the recipients of Coverdell distributions may be able to exclude the entire Coverdell withdrawal from income taxation. The recipient of the Coverdell distribution (and hence the person who may be liable to pay tax on the distribution) is the designated beneficiary. Contributions made to Coverdells are not deductible from income, meaning that contributions to these plans are made using after-tax dollars. In addition, there is an annual limit—$2,000—on the amount that can be contributed to all Coverdells for a given beneficiary. If contributions exceed this limit, the Coverdell beneficiary must pay a 6% excise tax on excess contributions. All Coverdell contributions are allowed to grow tax-free. Hence, unlike the typical bank savings account, where interest income is annually subject to income taxes, the increase in asset values in a Coverdell is not subject to current income taxes while assets remain in the account. Withdrawals from a Coverdell are not subject to federal income taxes if, for a given year, the distribution is used entirely to pay for adjusted qualified higher education expenses. In other words, if the amount of the distribution is less than or equal to the adjusted qualified education expenses (AQEE) incurred by the beneficiary, the entire distribution is tax free. If the distribution is used to pay for nonqualified expenses, a portion of the distribution—the earnings portion —is subject to income taxation and may be subject to a 10% penalty tax. In other words, if the amount of a Coverdell withdrawal is greater than the beneficiary's AQEE , the earnings portion of the withdrawal is taxable. The earnings portion of a distribution reflects the growth of the value of the Coverdell and not amounts originally contributed, which are sometimes referred to as basis. The percentage of the earnings portion subject to taxation is equal to the ratio of the difference of the total distribution amount and AQEE to the total distribution amount (see shaded text box). To ultimately calculate the amount of tax the taxpayer will owe, the taxpayer's marginal tax rates must be applied to this taxable income. Mr. Smith establishes a Coverdell for his daughter Sara. He makes an annual contribution of $1,000 over 10 years to Sara's Coverdell, for $10,000 in aggregate contributions. When Sara attends college, the account balance is $15,000 (i.e., the account balance has increased in value by $5,000) and Sara takes a $9,000 distribution to pay for her fall 2018 tuition payment of $9,000. But Sara also receives a $4,000 tax-free scholarship. Hence, Sara has $5,000 in AQEE in 2018 ($9,000 in tuition payments minus $4,000 in tax-free aid). Sara receives the $9,000 distribution and pays for $5,000 of AQEE using this distribution, thus she is liable to pay any income tax for the portion of the distribution used for nonqualified expenses. The steps to calculate the taxable portion of the distribution—and it is taxable because adjusted qualified education expenses ($5,000) are less than the Coverdell distribution ($9,000)—are outlined in Figure 1 . First, Sara must calculate the proportion of the distribution which is earnings. Since one-third of the account balance ($5,000) reflects earnings (two-thirds of the account balance reflects $10,000 of contributions), one- third of the distribution is attributable to earnings. Second, Sara applies the earnings ratio (in this case, one-third) to the distribution. Hence, of the $9,000 distribution, one-third or $3,000 reflects earnings. Finally, Sara calculates the proportion of the $3,000 earnings portion which is subject to taxation. The percentage of the earnings portion which is subject to taxation is equal to the ratio of the difference of the total distribution amount ($9,000) and AQEE ($5,000) to the total distribution amount ($9,000). Ultimately, as Figure 1 illustrates, of the $9,000 distribution, $1,333 of it is includible in Sara's income and thus subject to taxation.