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Saving For College, Part 7: Coverdell Education Savings Account

Contributed by mm | January 3, 2005 8:04 AM PST

Compared to 529 Plans, Coverdell Education Savings Account (ESA) is much less publicized.

How It Works

Previously known as Education IRA, Coverdell ESA is the Roth IRA for educational purposes. It allows parents to contribution up to $2,000 after-tax money a year for each child and receive tax-free growth of the capital if withdrawal is used for general educational purposes.

Pros

- Breadth of Investment Choice: Coverdell ESA has unlimited number of investment choices. Like Roth IRA, account owner can choose to invest in stock, mutual funds, money market, or any investment vehicle your brokerage allows.

- Favorable Financial Aid Treatment: Same as 529 Savings Plan, Coverdell ESA balance is treated as parents' assets, which are subject to about only 5% "tax" every year in the EFC calculation. (You might find contradictory information on this when you google this topic. It is because Department of Education changed rules in January 2004 to give Coverdell ESA the same financial aid treatment as 529 Savings Plan.)

- Broader Definition of Education Expenses: Coverdell ESA can be withdrawn for the following purposes and still maintain its tax-free status: tuition, room, board, fees, supplies, and special needs related to the attendance of a qualified elementary, secondary, or post-secondary institution.

Cons

- Scale: Current tax laws only allow annual contribution of $2,000 per beneficiary, which is much less than what 529 Savings Plan can be used to achieve tax-free growth.

- Phase-Out: A taxpayer's ability to contribute to a Coverdell account is phased out when the taxpayer is a joint filer with an adjusted gross income between $190,000 and $220,000, or a single filer with an adjusted gross income between $95,000 and $110,000.

- Control: In most cases, Coverdell ESA becomes asset of the child once he/she turns to 18. This means parents will have less control over the account, although parents still have the option to change beneficiary before the account becomes child asset.

My Personal Take

Actually, I love Coverdell ESA more than any of the 529 Plans. Coverdell ESA offers better growth potential than 529 Savings Plan as you can opt for financial products with less fees, and it's better than 529 Prepaid Tuition Plan because of the favorable financial aid treatment.

The annual contribution cap of $2,000 is certainly not desirable, but many of us should consider to fund Coverdell ESA first before considering 529 Savings Plan. The potential issue of losing account control when your kid becomes 18 can be generally avoided if you choose to roll-over the account balance to a 529 Savings Plan -- the rollover process is tax free if handled properly.

Next time, we will discuss Custodial Accounts (UGMA/UTMA). Keep tuned.

(This article is a component of the 10-part "Saving for College" series at PFBlog. If you want to read from the start, follow the links at this Table of Contents page.)

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