Feb 27, 2006

College Savings Series Part II: Coverdell Education Savings Accounts - Financial Tip of the Week (Feb. 27)

This is the second part in a series on saving for college. Part I: Options is here.

I'm a huge fan of Coverdell Education Savings Accounts. Except for the contribution limits, they are the ideal vehicle for college savings. The money grows tax-free, there is a wide range of investment choices, and the money can be used for expenses incurred prior to college.

Coverdells used to be called Education IRAs because they work a lot like Roth IRAs. You contribute post-tax money, up to $2,000 per year, and it grows tax-free. You invest it like you would in an IRA. Therefore, unlike with 529 plans, you have a lot of choice about how to invest your money. If you already have an IRA that you're happy with, you probably won't have to do a lot of research since you'll already be familiar with the investment options of the company your IRA is with. In selecting your investments, however, keep in mind that the time frame for when you will need the money might be different from your time frame for retirement and that you might want to allocate your money differently than you would for retirement.

The money in Coverdell accounts can be used as soon as your child enters kindergarten. That means you can use it to pay for private school tuition. Even if you plan to send your child to public school, a Coverdell can be an attractive option because you can use it for expenses like books and computers.

The biggest drawback with Coverdells is the relatively low contribution limit of $2,000 (the limit is lower if your income is over a certain amount, but the income threshold is quite high). There is a penalty for over-contributing, so you want to make sure that no more than $2,000 is contributed each year per child, especially if several people are contributing. There is no limit on the number of Coverdell accounts a child can have, so long as the contribution limit isn't exceeded. That means you can easily diversify your investments, for example by opening one Coverdell with a mutual fund company and another Coverdell with a bank so you can invest in a CD.

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