Planning for College: Education IRAs

Formally known as Coverdell Education Savings Accounts (ESAs)since 2002, Education IRAS are popular investments made on the behalf of a future college student. Along with 529 savings accounts, ESAs are very popular savings methods that many parents choose to start for the their children.

Setting it Up

While contributing to an account for one’s child is the most common situation with ESAs, these investment tools can be used to for the benefit of any future student regardless of his or her relationship to you, so long as the prospective beneficiary is under the age of 18 when the account is set up. In fact, even entities such as organizations or companies may contribute money to an ESA.

An ESA plan generally can be set up directly at any financial institution of your choice-- such as a bank, mutual fund company or credit union -- that offers traditional Roth IRAs, as the two investment accounts are very similar. Unlike the relative lack of control on the part of the account holder with a 529 account, it is up to you to decide how to invest your ESA contributions.: stocks, bonds, mutual funds, etc. However, there are substantial rules regarding ESAs that make them a bit more confusing than other investment accounts.

Contributions made to ESA accounts are devoid of federal income taxes, however there is a limit of $2000 annually that any beneficiary may have contributed to one or more ESA accounts on his or her behalf. If contributions (no matter who has made them) add up to more than this limit, then there will be a penalty for which the beneficiary him- or herself is responsible.


You may be asking yourself how one can plan for the huge costs of college when the limits to what can be invested in an ESA are relatively low. It is entirely possible to save money for a particular beneficiary in both an ESA and in a 529 account, so consider this if you do not feel comfortable about your investment potential from the ESA alone.

Additionally there are limits to who may contribute to an ESA based on income. If your income is more than the specified limits (currently $95,000 for a single person), then once again the beneficiary is responsible for the incurred penalty. One way to avoid this limitation would be to give the money you would like to contribute to your child as a gift, and then have him or her put it into the account.

Control of the Account

When you invest in an ESA account for a child, you become the “responsible adult” in charge of the account unless you appoint someone else to the position. Once the child turns 18, you may transfer this responsibility to him or her if you wish.

Despite this title, however, the money that you contribute is considered a gift, and eventually will become the property of the beneficiary. Unlike the situation with a 529 account, you cannot revoke your contributions or transfer your investment to yourself with an ESA.

The beneficiary may use the ESA tax-free funds for “qualified educational costs” at any public or private college, university, vocational school, or any other post-secondary educational institution. These costs generally include tuition, fees, room & board, transportation, and supplies like computers. (Under current legislation at least until 2010, ESA funds also may go to educational costs at primary and secondary schools as well.)

If the beneficiary decides not to attend college after all, then the ESA funds most likely will be provided to him or her within 10 days of the 30th birthday -- the date by which ESA funds must be withdrawn completely. If you still are the responsible adult on the account before this time, then you may roll over the ESA to another family member if you wish.


Additional Pros

• Non-taxable money.

• For individuals who want total control of investments, this probably is a better option than a 529 account.

• You can roll over an ESA into a 529 account if you choose.

• While contributing to multiple ESAs for the same beneficiary does not always make sense, it is completely your choice to take whichever route you think best.

Cons

• While it is possible to contribute to multiple ESAs for the same beneficiary, such action usually is not an attractive option because of the fees on each account.

• Having an ESA may affect financial aid eligibility.

• If a student uses Hope or Lifetime (Learning) credit on a tax return, then at least part of one’s ESA withdrawals might be taxable.

• Legislation is set to expire in 2010 that would lower the yearly allowable limit to only $500, and would disallow the use of ESA funds for elementary or secondary school costs.