To avoid allowing the country to fall off the fiscal cliff, Congress and the President have agreed upon and signed into law the 2012 American Taxpayer Relief Act (ATRA). Among other things, the new law restores nearly all of the tax incentives for education which had been scheduled to expire at the end of the year. One of these education incentives was the Coverdell Education Savings Account (ESA).
The Coverdell ESA is somewhat unique among the menu of fiscal tools that parents may use when performing their financial planning for college, because it operates much like a Roth IRA, and in fact was labeled the Education IRA from its inception until 2002 when it was restructured and renamed. The single greatest advantage of establishing a Coverdell ESA is that it is the only ESA available which allows parents to use the funds to pay for primary education; for example private school K-12. The second greatest advantage to investing in a Coverdell ESA is that you, the investor, are able to choose the investment vehicle.
A Coverdell ESA may be used to fund primary education
While it is certainly a good idea for Congress to encourage savings and long-term planning for college by parents, the array of investment options which they have designed to aid in this can make finance planning for college very confusing. With help from a Certified Finance Planner, the task becomes a great deal easier for parents.
The positive features of a Coverdell Education Savings Account will include, but may not be limited to …
- Earnings accumulate tax free
- Withdrawals for Qualified Education Expenses are also tax free
- Contribution limits were raised temporarily from $500 to $2000 (in 2002) and with the ATRA, the limit will not revert to $500 but will remain at $2000
- Contributions may be made by any family member
- Children can make their own contribution to the account
- Low contribution amounts are accepted
- The account belongs to the “responsible party” (e.g., the Parents) not the beneficiary
- Funds may be used to fund private education for K-12
- Withdrawals for K-12 education may be used for public, private, or religious education
- For students with special needs, there is more flexibility for what types of expenses may be deducted
The negative features of a Coverdell Education Savings Account will include, but may not be limited to …
- Contributions are made post-tax – they are not deductible, similar to a Roth IRA
- Contribution limit of $2000 is phased out for single contributors earning AGI of $95,000 to $110,000
- Contribution limit of $2000 is phased out for joint contributors earning AGI of $190,000 to $220,000
- Funding must cease once the beneficiary reaches the age of maturity (18 years old in most states) but may be extended for special needs beneficiaries
- The account must be fully withdrawn by the time the beneficiary reaches the age of 30, although this rule is relaxed for beneficiaries with special needs
- Funds used for a non-qualified expense will be penalized at 10% and will be taxed as ordinary income
For more information on the pros and cons of various education savings plans, take a look at this Comparison Chart from The Motley Fool. You may also wish to visit the 529 Guru to have some FAQs answered for you.
While the folks in Washington DC have tried to make it easier to encourage financial planning for college, the range of investment vehicles they have created to do so have become quite complex. The ramifications of these devices on your income and your tax bill, and the resultant confusion, may in fact reduce your incentive to participate. This could be a major mistake, for both you and your child.
As part of your comprehensive financial planning with a certified finance planner, your financial planning for college can be greatly simplified. Tamarind Financial Planning is here for you, with individual financial planning strategies and personal investment management techniques to help you set, meet, and exceed your financial – and life – goals.