An education in savings: the Coverdell ESA

It’s only natural that you want the best education for your children – from their first day of school to their final year of college. But a good education doesn’t always come cheap – especially when you are paying for pre-college and higher education costs.

For college savings, the 529 plan has become a very a popular choice among investors. The account’s investments grow tax-free as long as the money is used to pay for qualified higher-education expenses, including tuition, fees, books, supplies room and board.

But another alternative- the Coverdell Education Savings Account (ESA) may be used separately, or in conjunction with 529 plans, when saving for pre-college expenses.

Formerly known as the Education IRA, the Coverdell Education Savings Account became a more powerful education savings alternative in 2002, specifically for families wishing to save for pre-college costs as well as higher education expenses. Under the Economic Growth and Tax Reconciliation Reform Act (EGTRRA), the maximum annual contribution you can make to the account rose to $2,000 per beneficiary and account holder per year – four times the limit prior to the change. The earnings in the account grow tax-free as long as distributions are used for eligible expenses.

In addition to tuition, those eligible expenses include books, supplies, uniforms, transportation and academic tutoring costs for children in grades K-12 at both public and private schools – expenses associated with primary and secondary schooling that are often overlooked by other plans. As with most other college funding alternatives, any earnings withdrawal that is not used for qualified education expenses is taxed and is subject to a 10% penalty.

With the Coverdell, the account holder can allocate the funds in the account among stocks, bonds and mutual funds at his or her discretion. This may make the account more attractive than 529 plans, since they are much more restrictive for account holder allocations.

In contrast, Coverdells are not nearly as favorable when it comes to college financial aid eligibility: Funds in the account are regarded as student assets while 529 plans funds are not. However, EGTRRA allows the use of both alternatives in the same year and Coverdell funds may be rolled over into a 529 plan. This means you may be able to use the benefits of each at different stages of your child's education. When considering the Coverdell, note that there are provisions that prevent you from participating. An account can only be established for individuals under age 18 and the funds must be applied for qualified education-related expenses within 30 days of the beneficiary turning age 30. Of course, the age limit shouldn't be an issue if you'e using the account for elementary and secondary school expenses. Additionally, you cannot contribute if your income exceeds $220,000 and you are married and file a joint return. The limit is $110,000 for single filers.

For more information on the Coverdell ESA, 529 plans and other education funding alternatives that may help you save for your family’s education needs, contact me today.