Education Savings Account

 The Coverdale Education Savings Account, (formerly known as the Education IRA) is a powerful savings tool (see chart). Initiated by Congress in 1997, the  Coverdale Education Savings Account, mimics the benefits the Roth IRA offers for retirement. Contributions are made with after-tax money, with tax-free withdrawals for education expenses.

Hope permits a reduction in taxes up to $1,650 per student for first- or second-year college expenses. Lifetime Learning provides a tax reduction of up to $2,000 per qualifying family per year for college costs after that.

Effective,  January 1, 2002 the Coverdale Education Savings Account had the following changes:

• The annual contribution limit increases to $2,000 per student.

• Benefits become available to more taxpayers as the maximum allowable adjusted gross income for married filers increases to $220,000.

• Education expenses that qualify for tax-free withdrawals are expanded to include not only colleges, but kindergarten through 12th grade, too.

New qualifying expenses for K-12 are broader than just the tuition, fees and room-and-board allowed for higher education. Parents of younger students also may spend for such things as uniforms, transportation, extended day care — even home computers.

State-sponsored 529 plans

State-sponsored 529 college savings plans  let parents, relatives and friends invest for a child's college education. Under current federal tax law the gains on funds, used for qualified expenses like tuition, fees, books, room or board, are free of federal income tax. Many states offer similar income tax exclusions. 

Other improvements in 529 plans  made effective  January 1, 2002 are:

• You can switch to another state plan once every 12 months without changing the beneficiary. 

•  Allows beneficiary switching among cousins, as well as among members of an immediate family, a boon to generous grandparents.

Many states offer 529 plans. They caught on in part because there are no income restrictions on contributors. And they let you invest more than $100,000 per child. The plans can be switched to another child if the first beneficiary decides not to go to college.

The downside: If you need the money for a non-education purpose, you'll get hit with a 10% federal tax penalty, ordinary income tax and, in some cases, another penalty from the state.

529 plans are not created equally. Some plans go much further that just providing a vehicle to invest dollars for college expenses. They provide a very efficient estate planning tool. Under current tax law contributions made the 529 plan are not considered part of the owner's/contributors estate for estate tax purposes. Considering you can contribute up to $60,000 per beneficiary in a lump sum the estate tax planning ramifications are significant. In addition some 529 plans extend  the owner creditor protection of  the assets in the plan 

Higher education deduction

The law  created a federal deduction for college expenses, which could benefit parents who don't qualify for the Hope or Lifetime Learning credits.

An individual is allowed an above-the-line deduction for qualified tuition and related expenses for higher education paid by the individual during the taxable year. For taxable years beginning in 2004 and 2005, the maximum deduction is $4,000 for an individual whose adjusted gross income for the taxable year does not exceed $65,000 ($130,000 in the case of a joint return), or $2,000 for other individuals whose adjusted gross income does not exceed $80,000 ($160,000 in the case of a joint return). 

Another provision of the new law will help parents and students in the process of repaying school loans by making more of the interest deductible.

This provision has been extended through December 31, 2007.

Coordinating tax breaks

Once you understand the education provisions, you have to figure out how to make the most of them.

Effective January 1, 2002 you can take a tax-free withdrawal from a 529 plan or an Education Savings Account in the same year you claim a Hope or Lifetime Learning credit. But dealing with both on the same tax return will be tricky: School expenses covered by tax-free earnings cannot then be claimed for a Hope or Lifetime Learning credit.

The new law will not allow you to claim a tuition deduction and a Hope or Lifetime Learning credit in the same year for the same student. Parents who qualify for all of them may find that the deduction is more advantageous if their taxable income is above the 15% tax bracket. Here's an example. If a family with taxable income of $40,000 in 2002 spends $5,000 on qualified higher-education expenses, it would make more sense for them to take a $1,000 Lifetime Learning Credit, than a $3,000 deduction. The credit would cut their taxes by $1,000. The deduction would produce only $450 in tax savings.

If the same family also had an Education Savings Account or a 529 plan, it could use those tax-free funds to pay for the remaining $4,000 in expenses.

Selecting the best college savings option isn't easy. But don't let confusion paralyze you. The important thing is to start saving regularly.

Those who can afford to lock up money for college tend to opt for a 529 plan because there are no income limits. But Education Savings Accounts have the edge on at least two counts:

• Flexibility. Education Savings Accounts provide total freedom to direct investments.

• Certainty. Provisions of The Tax Relief Act set to expire in 2011 making withdrawals from a  529 plan subject to Federal  taxation to the student who gets the benefits have been amended. Now withdrawals are NOT subject to taxation.  Withdrawals from an Education Savings Account (or the old Education IRA), have never been taxable.

Coverdale Education Savings Account