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The Coverdell Account; An alternative to the 529 savings plan

Often hidden in the shadow of its better-known sibling, the 529 plan, the Coverdell Account may be a good, tax-free option for parents who plan to set up a college savings account. Although deposits are not exempt from taxes, the contributions grow tax-free once they are in the account—as long as funds are used for school expenses. Eligible expenditures include tuition, computer equipment, transportation, tutoring, uniforms, books and supplies.

Uniforms? Yes uniforms. One thing that sets the Coverdell Savings Account apart from its counterparts is that, in addition to college expenditures, account money may be used to cover elementary and high school expenses. This may be especially beneficial to parents who choose to enroll their children in expensive private schools that require, among other things, school uniforms.

The 529 vs. the Coverdell

In addition to grade-level flexibility, the Coverdell Account has an edge over the 529 plan in that it provides greater investment options. Deposits may be invested in the contributor’s choice of stocks, bonds, mutual funds and certificates of deposit. One can make changes in how the funds are used, and in doing so avoid watching hard-earned money slip through the cracks due to bad investments. Those that lose money may also be eligible to claim their losses on tax returns (this is also an option for 529 plan contributors).

There are, however, drawbacks to the plan. Unlike the 529 plan which allows for large contributions, the Coverdell Account has a $2,000 yearly deposit limit per child. Any additional deposits are subject to a 6% annual penalty fee. Also, the account must be created, and deposits concluded, before the beneficiary reaches the age of 18. After that, the beneficiary will have until the age of 30 to take advantage of their savings. If the savings are not used by that time, beneficiaries will have to either roll their savings over to a sibling under the age of 18 or face a 10% penalty fee. 529 plans, on the other hand, are open to both children and adults.

Is it Right for Me?

The Coverdell Account may be a good option for middle-class parents who are unlikely to contribute more than $2,000 each year. Keep in mind that this is a per-child limit and not a family limit. Families with multiple children may contribute up to $2,000 for each child.

Parents who have financial needs before their children enter college may also benefit from this plan. Many parents feel that sending their children to a private school is a good investment, but they may have trouble footing the bill. Tax-free incentives are useful in such situations—especially when students are too young to help out with part-time jobs.

High-income families may not benefit as much from this plan. In addition to the yearly deposit limit, the Coverdell Account has income restrictions on contributors. Single parents making more than $110,000 and married ones making more than a combined income of $220,000 may not take advantage of the plan. Single and jointly-filing parents making more than $95,000 and $190,000 respectively cannot contribute a full $2,000 each year.

Taking advantage of the Coverdell Account also does not mean that one has to give up on a 529 account. Combining parts of both plans may be a good option for some. For example, using the 529 prepaid plan option in conjunction with the Coverdell Account might make sense for some families. This allows contributors to purchase school credits at today’s rates and to put tax-free money aside. For more information on the Coverdell Plan, you may visit: http://www.irs.gov/publications/p970/ch07.html

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