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Part of the confusion with savings options for education is that the various names of the options tell almost nothing about the investment itself. By using obscure acronyms, inconsistent logic, and references to section numbers of legal provisions, the laws in this area seem deliberately crafted to make understanding them difficult.

One example of this is what was initially called an education IRA. Since IRA stands for "individual retirement account," the idea of an education/retirement account made no sense. Were the assets in the account for educational expenses or for retirement? Resolving the ambiguity required looking more closely at the provisions to figure out exactly what was included in the law.

In this case, Congress did the right thing by renaming the education IRA. Now named the Coverdell Education Savings Account or ESA, this method of saving for college combines tax advantages with the control that custodial accounts lack.

Basic provisions of ESAs
Coverdell ESAs closely resemble Roth IRAs in the retirement arena. Specifically, if you and your child qualify, you can set up an ESA for your child and contribute up to $2,000 each year. Contributions to the ESA are not tax deductible. However, since the assets inside the ESA generate investment income and capital gains, no current income tax is generated. Moreover, if the money is eventually withdrawn for qualified higher education expenses, the withdrawals will also be free of income tax.

Unlike some other education savings methods, a parent can make withdrawals from the ESA not only for college expenses but also for elementary and secondary school expenses. In other words, if a parent chose to send a child to a private school for kindergarten, the parent could withdraw money from the child's ESA and still have the withdrawal qualify for tax-favored status.

There are several rules that one must follow to use an ESA. Perhaps the most important is that unlike other types of accounts, the limit of $2,000 per year applies not to each account but to the total amount of contributions for any and all accounts for a particular child. For example, if a child's parents establish an ESA for their child and contribute $2,000 in a given year, then the child's grandparents may not make a contribution to a separate ESA established by them. Also, the named child must use the funds in the ESA by age 30; if any unused funds remain at that point, then the child must withdraw them and pay a 10% penalty because the money is not being used for qualified educational expenses. In addition, once the earnings of the ESA are withdrawn, the child will owe income tax on those earnings. This penalty and tax treatment also applies to any withdrawals that are made for non-educational purposes, with some exceptions related to scholarships and other alternative sources of educational funding.

If a family has multiple children and the oldest child does not exhaust the money in that child's ESA, then the parents can avoid the 10% penalty by changing the beneficiary of the ESA to another child. As long as the new beneficiary qualifies, then similar ESA rules apply going forward.

Income limits of $190,000 for a married couple and $95,000 for a single person apply to creating ESAs. These limits are rarely a problem, however, because even if the parents make more than the limit, the money can be given to the child and then the child can open the ESA account. Since children rarely have income over $95,000, the child is usually eligible to open the ESA.

Small but powerful
The main problem with Coverdell ESAs is that the $2,000 annual limitation prevents them from exclusively meeting the educational needs of most children. Even if you contributed the maximum every year from birth to age 17, the total value of the ESA with an 8% return would only be about $80,000, which is insufficient to pay tuition and expenses at current prices, let alone prices reflecting the expected level of inflation over the next 18 years. Because of these low contribution limits, financial institutions haven't pursued Coverdell ESAs with the same vigor with which they have embraced 529 plans, whose limits are much higher.

In addition, because the ESA funds are held for the benefit of the named child beneficiary, the parent cannot take any unused money back; it must be given to the child. Although the parent can generally change the beneficiary, grandparents or other individuals setting up accounts for children may not qualify for this particular power. On the other hand, because ESAs are not required to distribute unused funds until the child reaches age 30, many family members feel more comfortable with them than with the prospect of an 18- or 21-year-old gaining control over those funds.

As part of an overall college financial plan, Coverdell ESAs can be quite valuable. The fact that they can be used for primary and secondary school expenses can give parents the flexibility they need to address their child's particular educational needs. Coverdell ESAs are best used in conjunction with other savings vehicles, in order to ensure that sufficient savings are available to meet the child's educational needs.

This article was originally published July 18, 2006.

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