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Education Costs: Understanding Coverdell Education Savings Accounts

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Remember Education IRAs? The name is gone, but they’re still around. They’re called Coverdell Education Savings Accounts, and as the name suggests, they help people pay for everything from elementary and secondary school expenses, to college tuition and fees.

If you want to understand how a Coverdell ESA works, it helps to understand how a Roth IRA works. Both allow savers to make an annual non-deductible contribution to an investment trust account. The money grows free of federal income taxes, and if all goes as planned, withdrawals from the account will be completely tax-free as well. Of course, the big difference is the Roth is for retirement and the Coverdell is for education.

Coverdells have become a very popular way to save for college and other education expenses, but they are not for everyone. As there are for all investments, Coverdells have pros and cons.

Pros:

Coverdells can be used for kindergarteners, college students and everyone in between. You can use it to pay a wide range of expenses, including tuition, fees, tutoring, books, supplies, related equipment, room and board, uniforms, transportation and computers.

Contributions aren’t deductible on federal or state income tax, but earnings accumulate tax-free. And you don’t get taxed when you withdraw the money to pay for expenses. You have until the student reaches age 30 to use the money, or you can roll one Coverdell account over to a Coverdell account for another family member if the student didn’t use the money.

Cons:

The maximum annual contribution is only $2,000, and you can’t contribute after the student reaches 18. So most people who own Coverdells need other sources of income to pay for expenses at four-year colleges. Because the annual limit is only $2,000, your overall investment return can be affected by even a small annual fee charged by the institution that holds your Coverdell. So be sure to ask about fees before you open an account.

If the money isn’t used for education expenses, the earnings will be taxed as ordinary income, plus a 10-percent penalty.

You can open a Coverdell only if you earn less than $110,000 for a single filer or less  than $220,000 for a couple filing jointly. A grandparent can open an account for a student whose parents earn more than that, or a company, including a tax-exempt organization, can contribute to someone’s account.Unless Congress acts, certain education savings account benefits will expire after 2012. K-12 expenses will no longer qualify, and the annual contribution limit will drop to $500.

When it comes to whether you should invest in a Coverdell ESA, do your homework, and find a financial adviser or another trusted professional to help you understand whether it makes sense for you or your family.

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