Back when it was the Education IRA, not too much (despite the lure of tax-free income). In 2002, however, the re-named Coverdell education savings account became a very attractive college savings vehicle for many people, including families that wish to save for elementary and secondary school expenses as certain K-12 expenses were added to the list of qualified expenses. In fact, even if you like the 529 plan you may still decide to contribute the first $2,000 of savings for each child into a Coverdell account. There are some items to be aware of, however, such as the following:

  • There are certain eligibility requirements in the year you wish to contribute to the ESA, which means that not everyone will find them useful. For example, tax law prohibits ESA funding once the beneficiary reaches age 18.
  • In 2002, the contribution limit was increased from $500 per child to the much more reasonable level of $2,000. However, you need to be careful when accounts are established by different family members for the same child. If total contributions exceed $2,000 in a year, a penalty will be owed.
  • The relatively low contribution limit means that even a small annual maintenance fee charged by the financial institution holding your ESA could significantly affect your overall investment return.
  • Your contribution goes into an account that will eventually be distributed to your child if not used for college. You cannot simply refund the account back to yourself like you can with most 529 plans. This means you lose some degree of control.
  • The ESA is on equal footing with the 529 plan when applying for federal financial aid. The account is considered an asset of the account custodian, typically the parent. Withdrawals are not reported as student or parent income as long as it is tax-free for federal income taxes.
  • Coordinating withdrawals with other tax benefits, especially the Hope or Lifetime Learning credits, can be tricky.
  • The account must be fully withdrawn by the time the beneficiary reaches age 30, or else it will be subject to tax and penalties.
  • Unless Congress acts, certain ESA benefits expire after 2010. K -12 expenses will no longer qualify, the annual contribution limit will be reduced to $500, and withdrawals will not be tax-free in any year in which a Hope credit or Lifetime credit or Lifetime Learning credit is claimed for the beneficiary.
Understanding Coverdell education savings!

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