[Update: The Fiscal Cliff Bill of 2013 has made this post somewhat obsolete. ESA contributions have been increased back to $2000 per year and you can still use them for primary and secondary education. At this time (Jan 2013) Vanguard won't let you open a new one.]
Most of you are aware of what a 529 plan is. They are state-specific plans where you contribute after-tax money that grows tax-free, and if spent on education, is never taxed again. Before 529s were instituted, there was a similar type of account called an Education IRA or a Coverdell Education Savings Account (ESA for short.) Paul Coverdell was a Georgia Republican Senator (just like Senator Roth).
Like A Roth IRA
It’s just like a 529 except it’s run by a brokerage or mutual fund company instead of your state. Think of a Roth IRA for education. You don’t get a state tax deduction for contributing to it, but there are plenty of low-cost investing options if you opened it someplace like Vanguard or Fidelity, or use an account at TD Ameritrade or Schwab to buy low-cost ETFs. In fact, your investing expenses are often lower with an ESA than with a 529. I used them for a couple of years when I was an Alaska resident since there was no state tax deduction for using their 529.
Ridiculously Low Contribution Limits
So why don’t you ever hear about these accounts? The main reason is because the contribution limit is so low- only $2K a year (and it becomes $500 starting next year). Even if you start at age 0, contribute the max every year and earn 5% real on your money, that’s only $15K by the time junior hits 18. Compared to a 529 where you can contribute $13K a year, that’s a pretty important difference. When you combine it with no state tax deduction and the many cheap 529 plans out there (with their own advertising budgets), it’s no surprise that no one knows about these things.
Income Restriction
Many doctors technically can’t even use these things if they wanted to, since there is an income restriction. If you make more than $190-210K ($95-110K single), you can’t contribute. Of course, you can give the money to your kid who can make the contribution in his own name.
Congress Hates ESAs
Starting next year, you can’t use ESA money to pay pre-college education expenses anymore (think private high school), and its use isn’t deductible if you get a hope credit or lifetime learning credit. Combining that with the new $500 contribution limit, it seems to me that Congress just wants you to use a 529 instead. In fact, Vanguard won’t even open any new ones (although you can maintain and contribute to an existing one.) Don’t bother fighting them on this and just go with the 529. Even if you’re looking for another tax-protected (and lawsuit-protected) account, at $500 a year, this is ridiculous. See, I told you that you didn’t need to know what a Coverdell is.
yea i dont know why they just dont kill this in total. Maybe they consider this the humane way to kill it. One thing i believe to be true but not certain is that if you are contributing to a 529 then you cant contribute to both in the same year (at least more than the coverdell max which of course is very little). Thus even less reason to think about this.
Just as an FYI, contributions may be made to both an Education Savings Account and a 529 plan account in the same year. Although, there is not much of a reason do to both.
White Coat wrote:
Compared to a 529 where you can contribute $13K a year, that’s a pretty important difference.
I think there are much higher limits for 529 contributions. If you contribute more than $13K you must complete a gift tax return. You can gift 5 years of $13K all at once before you must use your lifetime exclusion which is $5,120,000 for 2012. Each individual 529 plan has its own rules for the maximum contribution that they will accept, but you can contribute this entire amount in one year.
thanks for the correction. i looked it up and the 13k with gift tax issues are the issues with doing both. as you mentioned at this point, not really worth doing it still.
You are correct that you can put in $13K x 5 all at once. In fact your spouse can put in another $13K x 5 as well. So you could stuff in $130K the year the kid is born and then forget about it without any gift tax/estate tax issues.
It’s sad how Congress killed what few, small advantages the Coverdell had. Might as well have just killed it formally instead of this death by attrition.
Maybe the $500 is intended to let those with existing accounts contribute enough to cover the fees? Just wild speculation.
I transferred the last of my ESA money out to 529s today. It was fun while it lasted.