Can You Use a Coverdell Account to Pay for a Student Loan?
A Coverdell Education Savings Account, called a Coverdell ESA, allows your child to receive tax-free savings to pay for college education expenses. The tax benefits are enforced by the IRS, and there are many expenses which won't be covered under the rules for allowable expenses under the Coverdell account. A student loan is one of those disallowed expenses.
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Feature
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Coverdell savings accounts allow your child to receive tax-free savings for college. It works by allowing you, the parent, to make contributions on behalf of your child. Then, you invest this money over time until your child is ready to go to college. You may use the funds in the account without paying income tax on this money as long as your child uses the money to pay for qualified education expenses.
Rules
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The IRS requires that your child to use the funds for either qualified higher education expenses, elementary or secondary education expenses. These expenses include books, tuition, supplies and even room and board. Basically, the expenses must be required by the school for your child's enrollment or they must be required for your child to stay enrolled. Students must also be enrolled as at least half-time students to be eligible for tax-free withdrawals.
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Disadvantage
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The IRS is very strict on what it allows in terms of withdrawals from Coverdell accounts. Student loans are not included as qualified expenses for college. The disadvantage here is that your child might incur substantial debts to go to school and may have to pay for those loans with money out of their own pocket even though you have saved up money to pay for these expenses.
Consideration
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When your child goes to college, you should encourage the use of the funds in the Coverdell account before any college education loan money is used. This will minimize the possibility of having to pay for debts out of pocket. There is one way to pay for college loans out of funds in the Coverdell account, but it is an expensive option. You may withdraw funds as a nonqualified withdrawal, pay income tax plus a 10 percent penalty tax on the withdrawal, and pay down the outstanding loan balance.
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