The Pluses and Minuses of Coverdell Accounts: A Look at the Benefits

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Almost everyone agrees (which is unusual) that higher ed is where it's at if you want your children to get the best start in their adult lives. And in a rare instance of unanimity, almost all the same people agree that you should save something to pay those eventual higher education costs. Where perfect agreement falls apart is when people discuss their "perfect" savings plan.

The truth is that there's no one perfect savings plan. What works for one person may be totally wrong for another, and rules governing one type of account may fit perfectly into one person's saving strategy while strangling another's attempts. Coverdell Education Savings Accounts (ESAs) are a perfect example. Although they may be real players in your strategy to save for your student's education, they're not the perfect solution for everyone. To use a Coverdell account effectively, you need to understand your financial situation now and consider where you think you'll be in the future to see if, and how, a Coverdell plan makes sense for you and your family.

Before you bog down in the minutiae of all the rules and regulations that go along with Coverdell accounts, take a couple minutes to reflect on some reasons why they can potentially be really good for you and your family.

Having Total Control

One of the great advantages of Coverdell ESAs (and the one that most banks and financial institutions spend a great deal of time telling you about) is that you, the responsible adult listed on the account, have total control over how the money is invested. If you want to be socially responsible and not buy into tobacco companies or companies that do business in countries that have repressive regimes, you can do that. If you only want to buy bonds, you can do that, too. You can also completely change your investment strategy on a dime. When the investments markets start to soar upwards, or conversely, begin to plunge, if you're paying attention, you can move your investments to take advantage of a perceived benefit or limit an impending loss faster than any institutional investor can.

Keep in mind, though, that with you in control, you not only take full credit for your successes, but you also bear the responsibility for your failures. And as anyone who's spent any time at all studying the stock and bond markets knows, some of the overall market failures have been spectacular.

To exercise that control to your best advantage, educate yourself about investing and what you need to do to make your student's account a viable entity.

Benefiting From Tax-Deferred And Tax-Exempt Growth

One great benefit of any tax-deferred account is that the money in it grows every time you receive interest, dividends (generally, corporate profits that are distributed to shareholders, usually in cash, but sometimes in additional shares), and capital gains (when you sell an investment for a higher price than you purchased it for, the difference between those two amounts is your capital gain) on your investments, and no tax issues arise until the money is taken out.

In a Coverdell ESA, if the money comes out and pays for a qualified educational expense, you pay no income tax on the earnings included in that distribution. If, on the other hand, you use the money to pay a nonqualified expense, your designated beneficiary must pay income tax on the earnings portion of the distribution, and then, depending on the circumstances of the distribution, an additional 10 percent penalty may be tacked on to your beneficiary's tax bill.

Paying For Primary And Secondary School Expenses

You may have absolutely no intention of sending your child to private or parochial school (although you can pay for private and parochial school fees by using distributions from your child's Coverdell account), and certainly many fine public school systems out there can provide your child with the very best education your tax dollars can buy. But still, there are always those extra expenses, the little things that come up year after year, such as tutoring, after-school programs, school busing costs (which are becoming more and more prevalent around the country), student athletic fees, and so on. The list seems endless, and as school budgets become tighter and tighter, this list will only continue to grow.

Until at least December 31, 2010 (and longer, if this provision of the law is extended), you may pay for all these big and little primary and secondary school expenses (including school uniforms, computers and peripherals, and any software for which you could conceivably find an educational purpose) by using tax-free distributions from your child's Coverdell ESA.