Guide to Coverdell

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The Armchair Millionaire's Guide to Coverdell Education Savings Accounts

What they are. Coverdell ESAs are investment accounts that allow you to save for a child's education. Formerly called Education IRAs (an amazingly confusing name), Coverdell ESAs are a straightforward, easy way to build your child's education fund.

How you'll save on taxes. If you know how a Roth IRA works, you know how a Coverdell ESA works. You fund the account with after-tax dollars, but then your money grows tax-free. As long as you use withdrawals from the account to pay for qualified education expenses (which include tuition, room, board and books), you'll never pay a dime of tax.

How you can use them. One of the nicest features of Coverdell ESAs is their flexibility. Unlike some college savings programs, you can use money from your Coverdell account to pay not just for college expenses, but for public and private elementary and secondary schools as well.

How much you can contribute. The child can have a maximum of $2,000 deposited in his or her account per year. More than one person can make contributions, but the total contributed still cannot exceed $2,000.

Who can contribute. Anyone can contribute to a child's Coverdell account-you don't need to be a parent, or even related at all. However, there are income guidelines that determine edibility. Single tax filers whose adjusted gross income is $95,000 or less can contribute, as can joint filers whose adjusted gross income is $190,000 or less. For people earning more than those amounts, eligibility decreases and eventually disappears as income increases.

How they can help. Let's assume that you open a Coverdell ESA for a newborn and contribute the maximum allowed amount of $2,000 each year. Let that money grow at an average annual rate of return of 10 percent, and you'll have a tad over $100,000 on hand by the time your child is 18 and ready to head for the ivory towers.

How to open one. You can open a Coverdell ESA at banks, mutual fund companies or brokerage firms. You can choose from a wide range of investments, including stocks, mutual funds and bonds.

THE BOTTOM LINE: When approaching any sizeable financial task, it's important to be flexible and ready to draw from a whole range of tools. When it comes to paying for college, Coverdell ESAs, 529 plans, custodial accounts, regular brokerage accounts and student loans can all be part of your tool box.

Coverdell accounts are OK, but a 529 plan is usually better. For example, NYS offers a tax deduction of $5000 single/$10000 maried to contributors. The beneficiary can be changed at any time, so it can be used for a series of children as they grow up or it can be used by the parents. Also, a Coverdell is in the childs name and is considered an asset of the child. For financial aid calculation purposes, this means that it will be calculated at 25% for yearly contributions toward education expenses. If the assets are in the parent's name, this liability will be reduced to 5.35% for these calculations purposes. For example, a child with a Coverdell in their name worth $5000 at time of calculation will be expected to pony up 25% per year, or $1250. The parents with a 529 will only be calculated at 5.35%, or around $250. Of course, total assets will determine eligibility for aid. Each state has it's own plan, but they are usually compatible with any other state.

Contribution limits are around $250,000 and anyone can contribute. If grandma and grandpa are estate planning, they can gift $55,000 (instead of $11K per year) all at once and spread the tax reporting out over 5 years.

The education savings plans are currently tax favored until 2010, at which time the favorable tax treatments are due to expire. If your horizon runs past this timeframe, be cautious. Yet, it is most likely that the tax treatments will be renewed as these plans have generated a lot of investment dollars since their inception. The 529 in particular has had a tremendous rise in popularity.
Also, in a pinch, a ROTH IRA can be used for qualified education expenses if it has been held for than 5 years. You won't be penalized for using it, but you will pay regular income tax on the growth associated with the withdrawn money. ROTH IRA are not calculated at all for financial aid purposes. And worse case scenario, your wunderkind doesn't go to school, the ROTH marches on to your retirement.

Prepaid tuition plans are counted dollar for dollar against financial aid calculations.

Good news for Coverdell owners. A new calculation system effective for 2004 FAFSA allows a Coverdell in a child's name to be calculated as an asset of the parent. This reduces the Expected Contribution treatment to 5.6% of assets as if it was in the parent's name.