Mechanics of Coverdells Savings Accounts: Getting A Handle On What You Want

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Before you ever start putting money into a Coverdell account, you need to know what you want to do and where you want to go with that money, some of which you may already have saved in a more traditional bank or brokerage account. None of these education savings options are as technically simple a savings technique as opening a bank account and making regular deposits into it. There are consequences to funding any of these accounts, and you need to understand not only what those consequences are but also how they fit into your and your student's future plans.

You need to be able to supply answers to all the following questions before making your initial deposit:

• What are you saving for? You may already be saving in another sort of plan, such as a Section 529 plan, for the major expenses, such as tuition and room and board. If so, picture this smaller plan as the place where the funds for some of your student's more personal expenses, such as books and supplies (and his computer, so long as he's still in high school or below, or if it's required by your child's college), can come from. Or, you may picture your student attending a private or parochial school long before he ever begins college, and you want this account to help pay for that. Have a clear idea in your head of how you plan for this money to be spent.
• Who will be your designated beneficiary, and whom do you have waiting in the wings as a backup? Saving money in a Coverdell account for the sake of saving money in a Coverdell account just doesn't cut it. You have to be saving for a specific person, and you have to have a reasonable expectation that the person you're saving for is going to need this money to pay for educational expenses at some point before her 30th birthday (or longer, if she's a special-needs student). What if you have any doubts whatsoever that you're not going to use up all the money you've saved over the years on that student? In that case, you may want to consider who can step into shoes vacated by your original beneficiary, either through choice or by necessity, whether it's another child of yours, a grandchild, or any other allowed relation of your original beneficiary.
• Who is actually going to contribute to your child's plan? You may not be the obvious choice here. All your good intentions and the practicality of this particular type of account may not amount to a hill of beans if you're prohibited from making contributions because you earn too much money. If you'll meet the requirements in some years but not in others, you may want to line up an alternate contributor who'll meet the income limitation requirements in years that you don't (even if you have to make gifts to that person in order for him to make gifts into the Coverdell account).
• What educational costs are you planning to pay for with the money in this account? Coverdell accounts are far more limited in terms of total size than Section 529 plans. (You're just not going to be able to put as much money into an account where the maximum annual contribution is $2,000 as you are in an account that basically has no maximum annual contribution.) These plans, however, are much more flexible in the type of expenses that you can pay for.

  You may want to consider just how much of your money you'll need in this account to pay for some of the expenses that your Section 529 isn't able to cover and try to limit the size of your Coverdell ESA to that amount and no more. For example, if you've invested in a Section 529 prepaid tuition plan, you may want to use distributions from your child's Coverdell account to pay for room and board, books, and other supplies. Or your secondary school child may be sooo close to achieving that perfect academic record and may need just a little extra tutoring in calculus in order to make the grade. In this case, paying for tutoring while in high school with Coverdell distributions may actually be a very savvy investment, as that extra edge may now qualify him or her for lucrative academic scholarships.

After you know for whom and how much you're saving, you're ready to jump in.