The Coverdell ESA

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By Robert Brokamp

Our friend the Education IRA has been given a new moniker: the Coverdell Education Savings Accounts. This was done in memory of the late Sen. Paul Coverdell (R-Ga.) -- and someone realized that the Education IRA had nothing to do with retirement, so why call it an IRA? The Coverdell ESA allows for a maximum annual contribution of $2,000 per student. Just open an account with a bank, brokerage, or mutual fund company, send in the contribution, and choose your investments. The earnings in the account grow tax-free as long as distributions are used for eligible expenses, which are not limited to college costs. The funds in a Coverdell can also be used to cover costs associated with attending elementary or secondary school, be it public, private, or religious. These costs can include uniforms, computers, and transportation. (Sorry, juice boxes and horse camp are not eligible expenses.)

A "responsible person" controls the account until the beneficiary reaches "the age of majority" (age 18 in most states, even if your daughter is still prohibited from dating). The person in control of the account chooses the investments, which can be stocks, bonds, mutual funds, or cash equivalents.

Any individual may contribute a maximum of $2,000 a year to a Coverdell ESA for the benefit of any person under age 18. But the contribution limit is phased out for contributors with a modified adjusted gross income between $95,000 and $110,000 for single persons and between $190,000 and $220,000 for joint filers. (The phase-out is ratable, i.e., if you're single and your income is halfway between $95,000 and $110,000, then you can contribute $1,000 -- half of the maximum.)

But if you exceed those income limits, don't worry. Just give the money to the kid and let him open the Coverdell ESA himself. For example, let's say Jocelyn, a single person, wants to establish a Coverdell ESA for her favorite little guy, Spanky. But Jocelyn's AGI is $130,000. Her maximum contribution to little Spanky's Coverdell ESA would be ZERO, because of the income limitation rules. But there is no reason that Jocelyn can't make a $2,000 gift to Spanky, who can then open his own Coverdell ESA with $2,000, since he's well under the income limitations (assuming his lemonade stand doesn't rake in more than $95,000 a year).

You have until the due date of your tax return (not including extensions) to make a contribution and still have it apply to the previous year.

Funds must be used by the time the beneficiary turns 30 years old. However, the account can be transferred to a relative (including cousins, step-relatives, and in-laws). If funds are used for a nonqualified expense, earnings will be assessed a 10% penalty and they'll count as ordinary income to the beneficiary.

See the College Savings Plan Comparison Chart for more nitty-gritty.

How to choose a Coverdell Education Savings Account

Coverdell ESAs are like any other investment account in that they are offered by brokerage firms, mutual funds, and banks. Keep fees, commissions, choices of investments, and other features (phone trades, research products, local offices, etc.) in mind as you make your choice.

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