College is extremely expensive these days. Using an education savings account (ESA), sometimes called a Coverdell Education Savings Account, is a tax-advantaged strategy of saving for college that can help make today's educational costs easier to manage.
Historically, this product has been popular with people in high tax brackets (read: wealthy folks). But you don't have to be rich to benefit from an ESA.
What is an education savings account?
ESAs are a regulated investment, so you must follow certain rules. The money put into this type of savings account must be for a specific person (such as your son or daughter). And a "responsible individual" must be named on the account.
In order to be eligible to contribute to an ESA, your adjusted gross income for the year in question must be no more than $110,000 if you are single and $220,000 if you are married. You can set up an ESA for yourself. The maximum contribution is $2,000 per year.
Are contributions to education savings accounts tax deductible?
Contributions are not tax deductible when they are made, but earnings on the investment and the original investment can be taken out at college time with no tax. In this respect, an ESA is similar to a Roth IRA, except that there is no "early withdrawal" penalty for an ESA.
If you did withdraw money from an education savings account for a purpose other than college expenses, you would have to pay tax on the earnings, but not on the contributions themselves.
Pros and cons of an education savings account
Grow tax-free savings
As noted, the big draw of an ESA is the opportunity for money to grow without being taxed, and then be withdrawn without being taxed. To take a simple example, if you put $2,000 into an ESA on the day your child was born, and the investment rose in value to $5,000 by the time your child headed off to college, you could take out the full $5,000 tax-free. In other words, you would be escaping the tax man to the tune of $3,000.
Generally speaking, the longer the time between the first contribution and the first withdrawal, the more the tax benefit can be. For this reason, education savings accounts are often used by grandparents to pay for their grandchildren's college expenses. Of course, this logic assumes that the money invested in the ESA has been managed properly and increased in value over time.
Value may not increase
The big potential negative about education savings accounts has to do with the assumption that the money invested in an ESA will be managed properly and increase in value. This is far from certain in today's stock market.
How do I invest in an ESA?
That said, the stock market has traditionally yielded better returns than any other investment over the last 50 years. You can also work with a financial manager to see that your contributions are directed toward investments that you favor, such as real estate or bonds.
In other words, your funds don't stop being yours when you put them into an education savings account. You're still the boss, so if the person managing your ESA isn't listening to your needs, you should feel free to take your money elsewhere.