In 2002, the Education IRA got an extreme makeover, including ditching the "IRA" portion of its name (helpful, since it has nothing to do with retirement). The Coverdell Education Savings Account is its much more attractive spin-off.

More than just a pretty name
If changing the name were its only improvement, the Coverdell's beauty would have stayed skin-deep. Fortunately, this is an education investment vehicle with some substance to back it up. Here's a quick rundown of the Coverdell's best features:

  • Unlike with 529 plans, in which you must choose from the mutual funds offered by the sponsoring institution, the Coverdell allows you to choose individual stocks.
  • The earnings on the Coverdell grow tax-free until the time of withdrawal. (Withdrawals may be tax-free, too, under certain circumstances.)
  • It can be used not just for qualifying college expenses, but for elementary and secondary school expenses as well (including books, allowable equipment, and room and board for students enrolled at least half-time).
  • Transfers to other family members are allowable, with certain restrictions.
  • If the beneficiary is an individual with special needs, the age limits do not apply.
  • You can open a Coverdell if your adjusted gross income is less than $110,000 (or $220,000 for those filing jointly).

Even the best-looking plans have baggage
Despite all the positives, you'll still want to take some time to get to know the Coverdell's less-attractive side. Here's the lowdown on its weaknesses:

  • The account will eventually be distributed back to the beneficiary (not his or her parents) if not used for college. Parents may not like the loss of control over their own contributions.
  • If you plan to use the Hope or Lifetime Learning benefits as well, you'll need to keep a watchful eye. The IRS doesn't allow double-dipping (i.e., claiming two or more credits for the same educational expenses).
  • Unless you want to be hit with a host of penalties and taxes, the money must be withdrawn from the account before the beneficiary turns 30. And you can't open a Coverdell for a beneficiary older than 18.
  • Account custodians will have to list the account as an asset if they apply for financial aid.
  • Beware maintenance fees from your Coverdell provider; they could eat into your savings.
  • If multiple folks are funding Coverdell accounts for little Johnny, they will need to coordinate to make sure the total contributed on his behalf across all of the accounts does not exceed $2,000.

Act now?
It's possible that, at the stroke of midnight on Dec. 31, 2009, the Coverdell will turn back into the proverbial frog -- returning to a $500 contribution limit, disallowing K-12 expenses, and making more of the withdrawals taxable (under some circumstances). So you'll want to keep your eye on whether or not Congress intervenes to extend the plan's best features. In the meantime, you may want to give the Coverdell a whirl.

Still not convinced? Read on for more:

This article is adapted from the Motley Fool Green Light "Money Answers" archive, which features more than 100 articles on personal finance topics such as taxes, credit, and beginning investing, organized by subject and life stage. For access to this content -- plus the current newsletter, back issues, members-only discussion boards, and advisor blogs -- take a free 30-day trial today!  

Fool contributor Elizabeth Brokamp is a licensed professional counselor who regularly talks money with her honey, Robert Brokamp, editor of The Motley Fool's Rule Your Retirement newsletter. The Fool has a disclosure policy.