The Educational IRA is another name for the Coverdell Education Savings Account. Still another name is the Coverdell IRA. This type of tax advantaged savings plan was created in 1997, the same year that the Roth IRA came on the scene. The Coverdell plan is very similar to how a Roth IRA works, but with a few twists.
The Coverdell is also not the only tax advantaged plan to save for higher education costs. A very popular type of plan is the 529 plan, which takes its name from the section of the tax code dealing with these plans. In fact, the 529 plan is many times more popular than the Coverdell due to reduced age requirements and lack of contribution limits.
In discussing the Coverdell IRA, you should compare it to the 529 plan to see which plan is best for your needs.
Coverdell IRA or a 529 plan
Both the Coverdell ESA and the 529 plan allow you to set up accounts for a beneficiary to pay for the cost of higher education. Unlike a custodial account where your child can spend the money anyway he wishes at age 18, the Coverdell and 529 plans can only be used for educational purposes.
Both these investment plans are set up like Roth IRA’s. You make after-tax contributions to the plans and all earnings or capital gains accumulate tax deferred. Then, if you make withdrawals to pay for higher education, the withdrawals are totally tax free.
Costs include tuition, books, fees, room, board, laptop, and even cell phones.
Differences between a Coverdell ESA and a 529 Plan
There are some important differences between the ESA and the 529 plan
The Coverdell ESA:
- In the ESA, the total contribution for any one beneficiary is limited to $2,000 per year.
- The $2,000 contribution limit will be reduced if your adjusted gross income is between $95,000 -$110,000 for single persons, or $190,000 to $220,000 for married persons. No contribution is allowed if your AGI is over the higher of these earnings limits.
- There are age limits in the ESA. The beneficiary must be under age 18 to receive contributions, and must make all withdrawals by age 30
- Funds may be used for private schooling between grades 1-12, as well as higher education
- Funds may be invested in just about any type of investment desired
- There are unlimited contributions to a 529 plan
- There are no age limitations
- Funds may only be used for higher education, not high school or grade school
- The investments under the 529 plan are handled by a number of investment managers chosen by the state in which you reside. While this allows for professional management of assets, the investment objectives of these funds may not match your own investment objectives
What if funds not used for Education
If your beneficiary decides not to go for higher education, you cannot simply withdraw the money. You can use the funds for the education of other family members: A family member includes: a son, daughter, or descendant of either; a stepson or stepdaughter; a brother, sister, stepbrother, or stepsister; a father, mother, or an ancestor of either; a stepfather or stepmother; a nephew or niece; an uncle or aunt; and a son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, or sister-in-law. It also includes the spouse of any of those persons
Recent Legislative Debate
In 2010, congress had voted to reduce the contribution limits to the ESA from $2,000 to $500 per year. They were also going to reduce the ability to use ESA funds to pay for private high school and grade school costs. However, a last minute reprieve extended the current limits and abilities.
This reprieve is extended until 2010 when the current rules will again expire. So keep abreast of legislative changes in the future.
Which Plan is better
On the surface it would appear that the 529 plan would be better since it permits higher contribution levels and there are no age limitations. On the other hand, the ESA allows for greater flexibility in investments and in what the funds may be used for.
If you are saving for a child’s college education, can contribute more than $2,000 per year, and are starting relatively early, the 529 plan is probably the better choice. If you want to save to pay for your child’s private high school, the ESA would be the better choice.
You Can Use Both Plans
There is nothing to say that you cannot belong to both plans. If you have different objectives for different children, consider opening both types of plans and split your contributions. For example, you are confident that your first child will want to go to college, and you can save $5,000 per year toward the cost. You should probably open a 529 plan. If that child does go to college, you can use the funds toward the college cost of another child.
If you think you want to send your second child to private high school, then use the ESA for these savings. You cannot use a 529 to pay for high school.
Whichever plan you choose, start early so you get the full advantage of tax free earnings. Starting these plans when your child is 17 does not do you much good.