Saving for College - Is a Coverdell ESA the best option?

Like an IRA, a Coverdell Educational Savings Account allows annual non deductible contributions. The funds in the account grow tax free and qualified distributions are also tax free. This may sound like a great way to save for college, but there are some catches.

• Contributions cannot be made to an ESA once the beneficiary turns 18.
• All funds in an ESA will have to be disbursed to the designated beneficiary by the time she turns 30 or the withdrawals will be subject to income tax and the 10%. Another technique is to rollover the account to another beneficiary who will have to be a family member.
• The maximum contribution limit is $2000 annually. Excess contributions are also penalized if they are not withdrawn before the end of the tax year.
• Distributions are only tax free if they're used for qualified educational expenses, otherwise a 10% penalty and income tax will apply to any gains that were withdrawn from the account. Double dipping and also claiming deductions such Hope and Lifetime Learning credits for the same educational expenses is not allowed.
• An ESA is considered to be an asset of the account custodian so this will not have a large negative impact on financial aid.
• For now, it is possible to make tax free withdrawals from an ESA and claim Hope or Lifetime Learning credits in the same year. This may change by 2010 though.

Paying rent for a new apartment with skylights and a jacuzzi is not a qualified educational expense! See the IRS publication on qualified educational expenses and distributions. Click here

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