A lesson in educational savings accounts
Schools days are expensive days. By 2020 a college education, depending
on whether your child attends an Ivy League or public university,
could cost between $90,000 and $195,000.
In the effort to meet this growing financial need,
revamped education IRAs are getting better marks. The original tax
preferences remain, and recent changes have made these often-ignored
accounts more attractive.
Now known as the Coverdell Education Saving Account,
named after late U.S. Sen. Paul Coverdell of Georgia, parents or
other adults set up these savings plans for children to use later
in their educational life.
More important than the name change is the revised
contribution limit. The annual amount that can be saved has gone
from a paltry $500 in the education IRA incarnation to $2,000 under
Coverdell ESA rules.
Another new perk: increased flexibility on when and
where you can spend Coverdell money. Cash from the accounts no longer
has to wait until young Jimmy or Sally heads off to State University.
Easier to use
Setting up a Coverdell ESA is easy. A parent, grandparent
or other loved one opens an account in a child's name. Remember,
though, that no matter how many people contribute, or if a child
has more than one Coverdell ESA, the total amount saved cannot exceed
$2,000 a year. Any more, and the Internal Revenue Service will levy
a 6-percent annual excess contribution tax.
Any company that can be the repository for a traditional
IRA can serve the same function with a Coverdell ESA. The money
can be invested in a variety of vehicles: stocks, bonds, mutual
funds, certificates of deposits, etc. The only investment that's
out-of-bounds for Coverdell accounts is life insurance.
The control over where and how the money is invested
appeals to many Coverdell converts.
"You can choose different portfolios and managers
to invest the money," says Michelle Bressler of PooleGoldstein,
a CPA firm based in Fort Lauderdale, Fla.
"Essentially you're not locked into a fund that's
a poor performer and having to ride it out," adds Joe Romano,
vice president of Romano Brothers & Co., an investment firm
in Evanston, Ill. "You can make a change."
Coverdell accounts also now can be used in conjunction
with other savings tools, such as state-sponsored
college savings and prepaid tuition plans. As education IRAs,
contributors were forced to choose between a private tax-deferred
savings account or a state-administered one.
Romano also points out that it's easier to move a
Coverdell ESA from one financial institution to another. "It's
the opposite of 529 plans, where it is very difficult to transfer
from one state's plan to another," Romano says.
Another improvement to the plan is added time to come
up with contribution money. While it is no longer called an IRA,
contributions to a Coverdell account now can be made up until the
April tax-filing deadline. Previously, money had to be put into
education IRAs by Dec. 31.
The tie-in to the tax deadline underscores one of the main
attractions of a Coverdell account: future tax savings.
Similar to a Roth IRA, money is taxed before it goes
into the Coverdell and the adults who contribute get no immediate
tax break. But, again like a Roth, the Coverdell earnings are withdrawn
tax-free as long as the money is used for approved schooling costs.
Just what does the IRS consider acceptable school
expenses? The good news now is that there's more flexibility on
how the money can be used.
"A new twist on it this year is that the money
can be used for tuition, computer equipment, uniforms, transportation,
books and supplies," says Elizabeth Lewin, co-author of Family
Finance: The Essential Guide for Parents.
Even better is the time frame in which it can be spent.
When the funds were classified as education IRAs, only costs related
to a child's secondary education counted. Now, Coverdell ESA money
can be used for expenses at all levels of education, from elementary
school through college. This is particularly helpful for parents
struggling to keep a child in private school.
No plan is perfect
Despite the improvements, there still are drawbacks to a
There are age limits on the child named as the account's
beneficiary. The student must, in most instances, be younger than
18. And Coverdell money can't be used indefinitely. In most cases,
the funds must be used before the child turns 30.
Unused funds, however, from an account set up under
one child's name can be rolled over into a Coverdell ESA for another
eligible family member. And special-needs children are exempt from
age limits for setting up and using the Coverdell ESA.
The account itself also might exact a cost. Since
only $2,000 can be saved, even a small annual maintenance fee charged
by the financial institution holding your Coverdell ESA can significantly
affect its return.
And, as with most tax-related programs, the rules
are confusing and the forms are complicated. For example, coordinating
the Coverdell ESA with other tax benefits, such as the Hope
Scholarship or Lifetime Learning credits, can be downright tricky.
Income is another obstacle for both contributors and the
For the year in which they contribute, account donors
must make less than $190,000 in modified adjusted gross income ($95,000
for single filers) or they cannot put in the full amount. Joint-filing
contributors earning $220,000 or more ($110,000 for single taxpayers)
cannot contribute at all. In these cases, your child can still qualify
for a Coverdell ESA if you give the youngster the money first as
a gift before it is deposited into the Coverdell ESA.
A well-meaning Coverdell account also could cause
income-related financial problems down the road. Since the fund
is listed in the student's name, it can be counted as income, thereby
potentially lowering the amount of financial aid your child might
be eligible to receive, says Lewin.
So, is a Coverdell ESA worth stashing in your child's
educational funding knapsack?
Romano believes it can be a good tool for middle-income
families who can't afford to contribute more than $2,000 annually
to a child's education saving fund. "My feeling is that the
reality is that it's going to be difficult for many middle-income
families to save more than $2,000 per year per child."
A Coverdell ESA also can be a great adjunct to other
forms of educational savings including 529s and prepaid tuition
plans, Romano says. "It has a nifty niche."
Jenny C. McCune is a contributing
editor based in Montana.
-- Posted: May 20, 2002