We plan to send our child to a private elementary school. Is a Coverdell Education Savings Account a good way to save?
Smart thinking. Opening a Coverdell Education Savings Account, or CESA, for early education expenses and a 529 for college expenses is a savvy strategy. As you probably know, withdrawals from CESAs (formerly known as Education IRAs) can be used for education expenses associated with any age, while 529 plans are restricted to higher-education costs. The beauty of both types of accounts is that earnings can be withdrawn tax-free, provided they're used for qualified expenses.
Withdrawals from CESAs are tax-free when used for all manner of education-related expenses, including tuition, books, supplies, transportation, uniforms, computers and even Internet access. Given this latitude, lots of parents could undoubtedly find occasion to make withdrawals from CESAs well before hefty college bills roll in. These accounts are also attractive because, like IRAs, they allow account owners to invest as they choose, whereas 529 college savings plans typically have fewer than 10 investment options to select from.
There are a couple of notable drawbacks to CESAs, however. One is that the total amount that can be contributed to any single beneficiary per year is $2,000. This means that regardless of how many people contribute to a child's CESA, the total cannot exceed $2,000 annually. (People can, however, contribute to as many different CESAs as they choose, an option especially appealing to grandparents.) Given these relatively low limits, a CESA isn't likely to cover all or even most of a child's education expenses, which is one reason why opening a 529 college savings plan -; many of which have contribution limits of $200,000 or more -; in conjunction with a CESA makes sense. That said, for those who haven't made a 2002 contribution to a CESA, the deadline is April 15, 2003, so right now parents (or whomever would like to contribute) can make both their 2002 and 2003 contributions at once, giving an account a generous $4,000 contribution.
The other drawback to CESAs is that not everyone can contribute. Contributions limits phase out for individuals with annual adjusted gross income (AGI) between $95,000 and $110,000, and married couples with joint AGIs between $190,000 and $220,000. (There are no income limits with 529 plans.) Of course, should President Bush get his way with his proposed "Lifetime Savings Accounts," all of this would change. That's because anyone, regardless of income, could save up to $7,500 annually in an account that would allow tax-free withdrawals for any purpose. This would certainly be a gift to many parents, but until it becomes law it shouldn't keep them from starting a savings strategy today.
Parents looking to use a CESA for college expenses should be aware that CESAs can decrease the amount of financial aid a child receives. Right now, the way a CESA will be assessed depends on whether the child is attending a public or private school. (In some cases, a 529 plan may be assessed more attractively than a CESA.) But regardless of which type of school the child attends, parents should be aware that withdrawals (rather than the total account balance) could be assessed at up to 50%. In other words, a school could expect that 50% of a withdrawal would be used toward college expenses, therefore reducing the financial-aid package by that amount. That said, we believe that a parent should never not save for their child's education expenses out of fear of a reduced financial-aid package. After all, these days, most financial aid comes in the form of loans, not grants. For more on how CESAs and 529 plans can affect financial aid, see our story.
So how should parents planning to tap a CESA for elementary-school expenses allocate their accounts? If the savings will be used within the next five years, be conservative and invest in bonds, says certified financial planner (CFP) Elaine Bedel, president of Indianapolis-based investment-management firm Bedel Financial Consulting. (Those concerned about the current interest-rate environment may want to create a laddered bond portfolio.) Those who won't take withdrawals until high-school age could invest the account in equity funds and begin to pare back as the deadline nears. For more on this, see our Short-Term Investing guide.
For more on CESAs and 529 plans, visit our College Planning section. Originally published on February 6, 2003.