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The ABCs of ESAs: 5 Things to Know About Coverdell Education Savings Accounts

By Alert Investor - Apr 7, 2016 at 10:19AM

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It's never too soon to start planning.

Spring is here. High school and college acceptances are rolling in, and before you know it, it will be time to start thinking about the next school year. And whether your young scholar will be part of the class of 2017 or 2035, it's never too early to start thinking about saving for future education costs.

There are several ways to make sure you're ready -- and one such way is with Coverdell Education Savings Accounts (ESA).

One advantage of ESAs, which used to be known as Education IRAs, is that they usually give you more investment choices than most other college savings vehicles. Another plus: withdrawals from ESAs are not limited to college expenses. You can use them much earlier to pay for expenses such as elementary or high school tuition. There is one catch, though: The account must be started and all contributions must be made before your child turns 18.

If you are thinking about opening an ESA, consider these five things:

1. ESAs give you plenty of investment options. You can buy and sell what you want, when you want with one exception: You can't invest in life insurance contracts. You can also set them up at almost any brokerage firm, mutual fund company, or other financial institution.

2. ESAs offer federal tax advantages. Earnings in ESAs grow on a tax-deferred basis, and withdrawals that are used for qualified education expenses are tax-free. However, like 529 college savings plans, you cannot deduct the money you contribute to an ESA from your income taxes.

3. ESAs can be used to cover some non-college education expenses. One benefit that ESAs have over other tax-advantaged educational saving options is that you can make tax-free withdrawals to pay for private elementary and high school expenses, as well as post-secondary school expenses. So if a private school is in your child's future, you could save for that expense in an ESA and use a 529 plan for college.

4. ESAs have contribution limits. There are two annual limits for ESAs. The first is that you can only give up to $2,000 to any one beneficiary if your modified adjusted gross income is below $95,000 as a single taxpayer and $190,000 if married filing jointly. The amount you can give phases out the higher your income is above that level -- and for the 2015 tax year you can't contribute at all if you make over $110,000 as a single filer, or over $220,000 if you file jointly with your spouse. You can find the current contribution limits on the IRS website.

For the second limit, the total of all contributions to all ESAs set up for one child cannot exceed $2,000 in a single year. If other family members also set up ESAs for your child, you'll need to coordinate with them.

On the plus side, as long as your salary is below the above thresholds, you can contribute up to $2,000 per child. Each ESA can only have one beneficiary, so if you and your spouse make a combined $150,000 and have two kids, you can contribute at total of $4,000 -- $2,000 for each child. As mentioned, just make sure you coordinate with any other family members. If Grandma contributes $1,000 to each child, then you can only contribute up to $1,000 to remain at or below that $2,000 per child cap.

5. They do come with costs. You will have to pay fees and expenses, which can vary with the investments you choose and the institution you invest with. Because of the fairly low contribution limits, even small annual fees or expenses could make a big difference in the return on your investment over time.

For more information about how an ESA compares to your other college savings options, check out FINRA's College Savings Comparison Chart. You can also check out FINRA's podcast on the topic here.

An Alert Investor is a smarter investor.

This article originally appeared at The Alert Investor.

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