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Tax laws keep changing, but don't be the last to know about them. Here's the latest filing scoop.

TAX TIP #66
Uncle Sam offers tax-free way to save on school costs

Sure you want your kids to have the best college education, but can you afford it? Uncle Sam may be able to help.

Among the various tax-favored college payment plans is the Coverdell Education Savings Account, previously known as an education IRA. When the account was renamed, it also was revamped, and Coverdell accounts now earn a better grade from taxpayers who are looking to stash cash for children's schooling.

In this tax tip:
 
 
 

Increased contributions
Up to $2,000 can be contributed to a Coverdell account (it was $500 in its earlier IRA incarnation).

Plus, you have more time to put the money in, can pay for more types of education expenses with the money and can combine Coverdell cash with other education tax breaks.

The basic account setup remains. While adults contribute to the savings plan, a child age 17 or younger is named as the account's beneficiary. The contributions aren't tax deductible, but they and their earnings can be withdrawn tax-free as long as they are used to pay eligible schooling costs.

New name, better benefits
But that's where the similarity between the old education IRA and the new Coverdell plan (renamed in honor of the late U.S. Sen. Paul Coverdell of Georgia) ends.

In addition to the increased $2,000 contribution limit, the Internal Revenue Service now allows:

  • Money to be added to the plan up until the April tax-filing deadline.
  • Contributions for a child 18 or older if the youngster has special needs.
  • Any adult -- parents, grandparents, godparents or friends -- to put money in a child's education IRA, but the total put in the account from all sources cannot exceed $2,000. There's a 6-percent annual excess contribution tax if more than that is contributed for the same child, even when the money comes from different people.
  • Higher income limits for contributors. To contribute fully, a person must make no more than $95,000 if filing as single taxpayer, $190,000 if married filing jointly. Limited contributions are allowed for single taxpayers earning up to $110,000 and married couples making up to $220,000. Beyond those higher incomes, a person cannot contribute. And remember, the contributions are simply for the future education of the child. The contributor gets no tax break for adding to the account.
  • Money to be used for some precollege expenses, including tuition, room and board, books and computers for public, private or parochial elementary and secondary schools.
  • Money to be simultaneously contributed for the same child to a Coverdell account and a state college tuition program.
  • A distribution from the account in the same year that the Hope or Lifetime Learning credits are claimed as long as the money is not used to pay for the same expenses.

Selecting an account home
OK, you've determined that a Coverdell education savings account is a worthwhile component of your child's overall educational savings plan. So where do you put the money?

Any financial institution (a bank, investment company, brokerage, etc.) that handles traditional IRAs can help you set up and manage a Coverdell account. You can put your contributions into any qualifying investment vehicle -- stocks, bonds, mutual funds, certificates of deposit -- offered at the institution that will serve as the account's custodian.

If you want to diversify, you can split the money up into several investments. There's no limit on the number of Coverdell accounts that you can establish for a child. The only limit is on the total contributions: You can't put more than $2,000 a year away for the student, regardless of how many accounts he or she has. Just be sure that management fees for multiple accounts don't eat into your overall savings return.

Unused Coverdell money
If Junior decides college is not really for him, what happens to any unused education IRA money diligently contributed all these years? Then Junior pays when he turns 30. He must take any balance in the account within 30 days of his birthday, and he'll owe tax on the earnings plus a 10-percent penalty.

The IRS, however, offers a way out of this taxable situation. Junior can rollover the full balance to another Coverdell plan for another family member. This could be a younger sibling, niece, nephew or even his own son or daughter.

For more information on education IRAs and other education tax breaks, check out IRS Publication 970, Tax Benefits for Education.

Freelance writer Kay Bell writes Bankrate's tax stories from her home in Austin,
Texas, and blogs on tax topics at Don't Mess with Taxes
.

-- Updated: March 30, 2007
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