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The education IRA

Question: My wife and I had our first baby in January of 2009 and are looking into saving for her education. I have heard a lot about 529 plans but very little about Coverdell accounts. So far I have learned that both 529s and Coverdell's allow money to grow and be withdrawn to pay for the education of the beneficiary tax-free. While the Coverdell does have a $2k/year contribution limit, contributions are also tax deductible while 529 contributions are not (at least in California). Why haven't I heard more about Coverdell accounts? Is there a reason why I would not max-out my Coverdell contribution and then put additional money into a 529? My wife and I make a combined taxable income of about $150k. Hans, Sherman Oaks, CA

Answer: The Coverdell Education Savings Account is one of the least understood ways to save for college. It used to be known as the Education IRA. In essence, it acts much like a Roth-IRA. You contribute up to a maximum of $2,000 in after-tax dollars--contributions are not tax-deductible--at a financial institution of your choice. There income phase outs and limits to the Coverdell. Joint filers with $190,000 or less in modified adjusted gross income qualify for the full $2,000 contribution. The income limit for single filers is $95,000 for single filers. For joint filers the contribution amounts is reduced for modified adjusted gross income between $190,000 and $220,000--after that you're out of luck. The comparable figures for single filers are $95,000 and $110,000.

The money compounds tax free. If it is used to pay for qualified educational expenses withdrawals are tax free too. Unlike a 529 plan, the account can be tapped tax-free to cover qualified education expenses at primary and secondary schools as well college.
Here's the rub: The annual contribution limit is $2,000 until 2010, when the figure drops to $500. A number of other college savings attractions attached to the Coverdell will end that year, too. I'm not sure why Congress liberalized the rules surrounding the 529 college savings plan in 2006 but left the Coverdell vulnerable to changes in its treatment in 2010. After 2010, the Coverdell will be a much less attractive way to save for college compared to the 529. That's why I favor the 529 plan.

But there is no reason why you couldn't contribute to the Coverdale to the maximum for now, in addition opening up a 529 plan. You can learn much more about the details of the Coverdell at savingforcollege.com.

About the author

Chris Farrell is the economics editor of Marketplace Money.

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