Should I use a Coverdell ESA?

A Coverdell ESA is one of the two main types of college savings accounts, along with the 529 Savings Plan. While the Coverdell has a lower $2,000 annual contribution limit, accounts can hold a wide variety of stocks, bonds, or funds. All withdrawals of investment growth are tax-free, when used for qualifying education expenses.

Details of a Coverdell ESA: Contribution limits and investment options

A Coverdell ESA (Education Savings Account) is a tax-advantaged account designed to help save for educational expenses.

Similar to a Roth IRA, contributions are made to a Coverdell ESA on an after-tax basis, which means that you don't get a tax deduction for the money you deposit. However, qualified withdrawals of contributions as well as investment profits for educational expenses are 100% tax-free.

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The contribution limit for a Coverdell ESA is $2,000 per year, per beneficiary. This means that if a beneficiary has more than one Coverdell, the combined contributions to the accounts can't exceed $2,000, and no contributions can be made after the beneficiary's 18^th birthday. You can contribute to a Coverdell ESA for a certain year any time before that year's tax deadline. In other words, you can make your 2016 contributions until April 15, 2017.

The ability to contribute to a Coverdell ESA phases out for individual taxpayers with modified adjusted gross income (MAGI) above $95,000 and disappears completely for MAGI above $110,000. For married couples filing joint tax returns, these limits double to $190,000 and $220,000, respectively.

Coverdell ESAs are offered by many brokerages and other financial institutions. Contributions can be invested in virtually any stocks, bonds, or mutual funds, making them great choices for savers who want maximum control over how their funds are invested.

How can you use the money?

Money in a Coverdell ESA must be used for qualified education expenses -- any non-qualified withdrawals may be subject to a penalty.

Unlike most other educational savings accounts, a Coverdell isn't limited to higher education. Certain elementary and secondary educational expenses also qualify. This is one of the biggest advantages of a Coverdell. For example, if your child needs a tutoring service in high school, you can use funds from your Coverdell to pay for it.

Qualified expenses include, but are not limited to:

Tuition and fees

• Books, supplies, and equipment required for enrollment
• Room and board (if attending at least half-time
• Computer and related equipment if used for school
• Special needs services

For elementary and secondary students, academic tutoring and required expenses such as school uniforms qualify as well.

Finally, one of the most common questions is "What is my child doesn't need the money?" For instance, what is the beneficiary gets a scholarship, or doesn't end up going to college at all? In this case, the funds are transferable to another beneficiary, such as another child, and the process is rather painless. Or, you can always choose to take out the money and incur taxes and penalties, although I wouldn't suggest that option.

You may be surprised at how much $2,000 per year could produce

So, what kind of college fund could you build up with a Coverdell ESA? Theoretically, the maximum possible account value is unlimited, since it's based on your investment performance.

As an example, let's say that you open a Coverdell ESA when your child is born, and contribute the maximum of $2,000 every year for the next 18 years, so $36,000 altogether. Based on a historically conservative 7% rate of return on your investments, the account could grow to $72,758 by your child's 18^th birthday -- more than double the amount you put in.

Here's an easy-to-use calculator that can show you the power of the Coverdell ESA, as well as the potential tax savings you could get.

* Calculator is for estimation purposes only, and is not financial planning or advice. As with any tool, it is only as accurate as the assumptions it makes and the data it has, and should not be relied on as a substitute for a financial advisor or a tax professional.

Is a Coverdell ESA the right option for you?

It depends. Coverdell ESAs are great options for people who like picking specific investments, or may need to use the money for education expenses before the beneficiary gets to the college level. However, the low contribution limit relative to 529 savings plans is a limiting factor for many people. In a nutshell, your personal preferences and savings goals should be taken into account when deciding whether a Coverdell, 529, or a combination of both is the best option for your college savings plan.