Ok…so the real name of an IRA that can be used for education expenses is called a Coverdell Education Savings Account (Coverdell ESA).  However, for simplicity sake, we in the accounting world generally refer to these powerful little gems as the “Education IRA”.

Regrettably, not everyone in the accounting world believes the Education IRA to be a precious gem.  Mostly because they don’t understand their hidden benefit and strategy.  Thus, in my opinion, the 529 college savings plans are oversold to the public and no one really talks about the Education IRA.

Let me set the record straight and share what I think to be one of the most incredible ways to save for college education. First, the good news:

  • Think of a Coverdell ESA as simply an IRA…any investments inside the IRA grow tax free and come out tax free for any qualified education expenses (typically tuition, books, fees, etc…)
  • Each person, child or beneficiary can have their own Education IRA and anyone, including themselves can contribute to it.
  • Contributions can be made up until April 15th for the prior year.
  • Beneficiaries may withdraw the money tax free for qualified elementary and secondary school expenses- Not just college expenses.  This means you can pull money out tax free for private elementary, middle or high school (something you can’t do in a 529).
  • These plans can allow almost any investment inside including stocks, bonds, mutual funds, real estate and private ventures. Think self-directing into any investment you could with an IRA or 401k.  This could ultimately allow for unlimited rates of return on your investments (while 529 plans only allow a choice among a number of state run allocation programs and the rates of returns are dismal).
  • The custodian/owner of an ESA can designate a new beneficiary without incurring taxes or penalties provided that the new beneficiary is an eligible family member of the previous beneficiary.
  • Money in Coverdell ESA is not considered the child’s (beneficiary’s) money when applying for federal financial aid as long as the owner of the account is someone other than the beneficiary, such as a parent

Now, in my opinion, there are really only two significant drawbacks

  • You can only contribute $2,000 per year, to a beneficiary’s Coverdell ESA account.  However, keep in mind investment returns can essentially be unlimited (hence my note on the ‘hidden benefit’ below), and
  • The income level of a donor may affect contributions into a Coverdell ESA (just get grandpa and grandma involved)

Important differences with the 529 Plan. I noted several differences between the 529 and ESA in the lists above, however, probably the most recognized is that contributions to a 529 can be significant and up to any amount necessary to cover the beneficiaries college expenses (keeping annual gift tax exclusions in mind).  Because of this ability to sock away big money, many people feel these ‘plans’ are the route to take in order to actually ‘save’ for a beneficiary’s college.  However, when the rates of return inside a 529 are barely better than a CD at the local credit union, I question how wonderful this contribution limit really is.

The Hidden Strategy. The little known fact that can transform your college savings account/Coverdell ESA/Education IRA into a powerhouse for college savings is the fact you can self-direct the investments.  Hence, you can use leverage and sometimes make a small investment that can pay enormous returns and in turn accelerate your college savings account very quickly.

What is a Qualified Education Expenses?  Essentially, this term means tuition, fees, books, supplies and equipment required for study at any accredited college, university or vocational school in the United States and at some foreign universities. However, the money can also be used for room and board, as long as the fund beneficiary is at least a half-time student. Off-campus housing costs are covered up to the allowance for room and board that the college includes in its cost of attendance for federal financial-aid purposes.

In summary, many a parent understands the seriousness and stress ‘college savings’ can place on a family.  However, just as a retirement savings plan, the best strategy is to just start saving now, and in my opinion, start self-directing your Education IRA as soon as possible to reap the highest possible rates of returns.  As a parent with 3 kids in college this year, let me encourage you to take this seriously and just get started with something and don’t give up.

* To sign up for Mark’s weekly Free E-Newsletter and receive his Free E-Book “The Top 10 Best Tax Saving Secrets Everyone Should Know” visit www.markjkohler.com.

Mark J. Kohler is a CPA, Attorney, co-host of the Radio Show “Refresh Your Wealth” and author of the new book “The Business Owner’s Guide to Financial Freedom- What Wall Street isn’t Telling You” and, “The Tax and Legal Playbook- Game Changing Solutions For Your Small Business Questions” He is also a partner at the law firm Kyler Kohler Ostermiller & Sorensen, LLP and the accounting firm K&E CPAs, LLP.