Coverdell Education Savings Accounts

Introduction
Formerly known as Education IRAs, Education Savings Accounts (ESAs) are another tax-advantaged way to save for college. ESAs have similarities to both 529 plans and custodial accounts, and they have unique features as well. The investments in these accounts are managed for the designated beneficiary by a “responsible individual,” who may also be the contributor.

Linda Stewart for www.fizone.com

March 2003

Costs Involved

Contribution Limits: The maximum annual contribution per beneficiary is $2,000. Contributor’s income must not exceed $110,000 (single filer) or $220,000 (married, filing jointly). The allowed contribution amount begins phasing out at $95,000 and $190,000 respectively. Contributions are not tax-deductible.

Fees and Expenses: There are no specific fees or expenses for a Coverdell account, although the brokerage firm or bank may have administrative charges. Individual investments will have commissions or fees normally associated with trading.

Education Costs that Qualify for Withdrawals: Withdrawals do not have to be for post-secondary education; they can also be for elementary or secondary institution costs. Qualified expenses include most student needs: tuition, books, uniforms, supplies, room and board, etc.

Taxation Issues
Earnings on your investments are tax-deferred until withdrawn, and tax-free if withdrawn for qualified expenses. If the beneficiary reaches 30 years old before withdrawing all the funds for education, the remainder can be rolled over to another beneficiary. Otherwise, the remainder will be distributed to the beneficiary, and taxes may apply.

If you are claiming a Hope or Lifetime Learning Credit, or deducting tuition, there may be some portion of even qualified withdrawals that is subject to taxation. In other words, you cannot claim the tuition expense both ways.
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The Beneficiary
The beneficiary must use the ESA funds for educational expenses by the time he or she is 30 years old, except for designated individuals with special circumstances. When the beneficiary becomes a major, the responsible individual continues to manage the account.

Financial Aid Eligibility
According to the savingforcollege.com site, “The Coverdell education savings account can be a disadvantage when applying for federal financial aid. The account is considered an asset of the student, not the parent. Withdrawals while in college can also produce a harsh effect on the following year's aid eligibility because it is counted as student's income.”

Investment Choices
Investment options are basically limitless, except for life insurance contracts. The $2,000 per year maximum contribution limits investment potential somewhat, but whatever growth can be achieved and spent for education will be tax-free.

Recommendations
In my opinion the Coverdell account can be an attractive option under these circumstances:

Your income qualifies for contributing to such an account.
You would probably not contribute more than $2,000 per year anyway.
You or someone else as the responsible individual can make good growth investments.

If you have other objectives and are interested in alternative college savings options, read the overviews on 529 plans and custodial accounts.