Ask Dr. Don By Don Taylor, Ph.D., CFA • Bankrate.com

Coverdell education savings accounts

Dear Dr. Don,
Where can I get the best rate for an education IRA?
Clifford College

Dear Clifford,
Education IRAs have been renamed Coverdell Education Savings Accounts (CESA), and the contribution limits have been increased to $2,000 per beneficiary in the 2002 tax year. Other changes include:

• The income phase-out increases for joint filers.
• Qualified education expenses include elementary and secondary school expenses.
• Age limits do not apply to "special needs" beneficiaries.
• Contributions may be made until April 15 of the following year.
• Tax-free distributions can be used for special-needs services.

There's a lot of flexibility in how you set up a CESA. You can set a CESA up as a brokerage account, a bank account or directly with a mutual fund company. Keep an eye on the account's fees and expenses because they can really influence the returns on the investment.

Asking for the "best rate" on a CESA suggests that you're looking for a CD or bond investment because stocks or stock mutual funds won't have contractual interest payments.

If you want a guaranteed rate of return with no risk to principal, you should invest the money in U.S. Treasury securities or insured certificates of deposit. The CD rates offered for a CESA should be comparable to the rates offered on an IRA CD, and you can review IRA CD rates using Bankrate's IRA Center.

The longer you have until the beneficiary needs the money for qualified college expenses, the more risk you can take in how you invest the money, and an investment in a stock mutual fund may be more appropriate.

If you haven't made a contribution to a CESA for the 2001 tax year, it's too late to make one now. CESA accounts for the 2001 tax year had to be funded by Dec. 31, 2001. In 2002 and later tax years, you'll have until your tax filing deadline to contribute to a CESA.

There are income restrictions on who can contribute to CESA accounts, and the contribution totals are per beneficiary. The contribution limit is phased out at income levels between $95,000 and $110,000 for contributors who file individual (single) returns and from $190,000 and $220,000 for contributors filing joint returns.

A CESA can impact the beneficiary's ability to qualify for financial aid. If you expect students to qualify for financial aid, it may not be in their best interest to open a CESA for them.

It also requires some planning to use the account in conjunction with Hope or Lifetime Learning tax credits. That's because education expenses paid with monies from a CESA can't also be used to qualify for the Hope or Lifetime Learning Credit.

The three main choices for tax advantaged investing for college savings include CESA, Section 529 prepaid tuition or college savings plans, and the Education Bond program offered by the U.S. Treasury.

Which program is right for you depends on how much you plan on contributing, how long until the beneficiary will start to use the money, your income level, and your attitude toward risk when investing. Take a look at all three options before deciding where you want to invest.

-- Posted: Jan. 15, 2002