Investment Tips: What Is A Coverdell Esa?

A Coverdell ESA is a great way to plan for your kids' educational expense. Learn about this type of account and whether you qualify to open one.

Deciding on their children's education is one of the more important issues parents grapple with. Deciding between school districts, whether or not to send their children to a public or private school, and concerns about college all plague the conscientious parent. And with the cost of education expenses skyrocketing every year, most parents find themselves fretting about how they are going to pay for all of this. Fortunately, there are plans which exist to make the financial aspect of the education question a bit easier. More and more, parents concerned about paying for their children's education expenses are turning to Coverdell Education Savings Accounts (or ESA's) to plan for the future.

The Coverdell ESA, formerly known as an Education IRA, is simply an investment account set up at a bank or brokerage firm in which the funds are earmarked only for qualifying educational expenses. They behave in many ways like Roth IRA's - you control the investments, and though the contributions are not deductible, the earnings on the investment grows tax-free so long as the distributions are used for eligible educational costs. Better yet, the distributions are tax-free so long as they do not exceed the education costs of the beneficiary in that year.

Any child under the age of eighteen, known as a beneficiary, qualifies for a Coverdell ESA. The account must be opened and the investments controlled by an adult, although the beneficiary as well as anybody else, including organizations and corporations, can contribute to the account itself. The maximum amount that can be contributed to a Coverdell ESA in any one year is $2,000, regardless of who is dong the contributing. If for example, you put $1,500 dollars into a Coverdell ESA for your teenaged son, who has a part-time job. If he wants to contribute to his ESA, he can only put in $500, since that will raise the total contribution to the ESA to $2,000. There is no limit to the number of ESA's a beneficiary can have, but the total limit of contributions allowed is still $2,000. For example, if you have opened an ESA for your son, and his grandparents have opened an ESA for him, both of you couldn't contribute $2,000 in any given year for him. Instead, the total between the two accounts must be $2,000 or less.

There are some limitations as to who can contribute to a Coverdell ESA. If you are filing individually, and your income is less than $95,000, you can contribute the maximum amount. If your modified AGI is between $95,000 and $110,000, the amount you can contribute varies based on your income. If your modified AGI is above $110,000, you cannot contribute to a Coverdell ESA. For married couples filing jointly, the limits are $190,000 for maximum contributions and between $190,000 and $220,000 for reduced contributions. If your income is above $220,000 you cannot contribute. However, if this is the case, and you really want to contribute to somebody Coverdell ESA, there is no rule stipulating that you can't gift the money to somebody else - your child, for example - and have them contribute, so long as they are eligible to do so.

What qualifies as eligible educational expenses? First, it is important to note that the costs do not necessarily have to be college expenses, although this is a commonly held notion. Elementary and secondary school expenses qualify as well. Tuition, fees, books, supplies, computers, uniforms, and academic tutoring all qualify as eligible so long as they are directly related to the beneficiary enrollment at an elementary or secondary school. For college expenses, the student must be enrolled at least half-time, and expenses can included tuition, fees, supplies, computers and other equipment, and room and board. Be careful though! Some expenses, such as room and board, cannot exceed certain guidelines established by the IRS.

Once the child turns eighteen, he or she can take control of the Coverdell ESA. Again, it is important to make sure that the distributions are made for qualifying expenses, otherwise there will be tax and penalties on any income received from the account. Distributions from the ESA must be completed by the age of 30 - at that time the rest of the money is automatically distributed and taxed unless the beneficiary rolls over the distribution within sixty days to a younger family member. Another option is to simply change the name of the beneficiary to a family member who is under thirty years old. Family members can be anybody in your immediate family, including step-children or step-siblings, and first cousins.

If you have tax questions about your Coverdell ESA, refer to IRS publication 970 or speak with a tax professional. The Coverdell ESA provides a great opportunity for parents and their children to work together to pay for future education expenses. If you are interested in opening an ESA, dicuss with a financial planner or a bank representative which investments might be best for you.

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