Coverdell ESA

Another of the relatively new, innovative tax favored ways of funding higher education expense is the Coverdell Education Savings Account.  The use of Coverdell ESAs was recently expanded to allow for the funding of elementary and secondary school expenses (as well as higher education expense) at both public and private schools.  The ESA has a fundamental feature common to the Roth IRA we discussed under Retirement Planning (page 75).  Like the Roth, the ESA does not provide a tax deduction in the year in which it is funded.  However, there is never any taxation of the earnings or principal if they are withdrawn and used to pay qualified expenses which include not only tuition but also books, fees, supplies, room and board expense (if the student is enrolled at least half-time) and computers for school use.

The qualified Educational Savings Bond (discussed earlier) also yields tax-free interest income.  The ESA, however, can be invested in higher yielding stock mutual funds. Unlike Qualified Tuition Programs (discussed below), where this investment transition is done for you, you will typically need to do it yourself in an ESA.  If you invest in an ESA re-read the Transition of Investment Strategy section under Retirement Planning earlier in the book.  In a nutshell, comparing that discussion to investing in an ESA, you should invest in higher yielding, but riskier, stock funds until you are five or six years from needing the money, at which point you will start transitioning into lower yielding but safer investments.  See for example, the investment options open to you in a Schwab Coverdell ESA by going to my Web site, clicking on Educational Savings and then Coverdell Education Savings Accounts.

Taxpayers may deposit up to $2,000 per year into an ESA for a child who is under the age of 18.  The child can get no more than $2,000 per year from any and all sources — you and Grandma can’t each give the child $2,000 per year.

An attractive and flexible aspect of the ESA is that if the child does not need the money because he or she gets a scholarship or decides not to go to college, the wealth inside the ESA may be rolled over for the benefit of other family members.

Again we have an Adjusted Gross Income (see pages 9-10) phase out of the ESA benefit.  The phase out starts out at a much higher level than we have seen in our prior educational funding tools: it begins at $190,000 of AGI for married taxpayers filing jointly and is completely phased out once AGI reaches $220,000 ($95,000/$110,000 for a single taxpayer).

More information on the ESA is available from my Web site by clicking Educational Savings off the main menu and then Coverdell Education Savings Account.