A reasonable alternative to 529 plans.
Coverdell accounts, originally known as education IRAs, have been around since 1998 but were hobbled at first with restrictions that made them unattractive to many people. Tax changes in 2001, which took effect in 2002, turned this 98-pound weakling into a powerful alternative for college savings — and allow it to be used for pre-college education, too.
Name game: Despite the original name, the education IRA never had anything to do with retirement savings. Their official title now is Coverdell education savings account, a name that begs to be shortened. We’ll call them Coverdell accounts, but you may see other people call them education savings accounts or ESAs or CESAs. All refer to the same animal.
Briefly, these accounts works pretty much the same way as a Roth IRA or 529 account:
- You don’t get a deduction when you contribute.
- Earnings within the account are not taxed.
- If you follow the rules for use of the account, the earnings will be entirely tax-free.
You can’t ask for much more than that. The main problem for these accounts, prior to 2002, was the pitifully small limitation on annual contributions: $500. Now you can contribute $2,000 per year, and that means the Coverdell account can be used for serious savings. Some other favorable changes took effect in 2002:
- More uses. Qualifying uses of Coverdell account money now include expenses for kindergarten through grade 12 as well as college — and you can use the account to pay for a computer that’s used by your child and by others in the family.
- Easier to contribute. The income limit for contributions is increased for married couples filing jointly.
- Flexible timing. You can make a contribution for any year up until April 15 of the following year.
- Other tax breaks. It’s now easier to use Coverdell accounts without giving up other tax breaks for education, such as 529 accounts, the Hope scholarship credit and the lifetime learning credit.