The Education IRA: How Does It Compare?

The education IRA is a type of savings plan that allows you to put money away for a child's education expenses. This type of plan is also referred to as the Coverdell ESA. Here are the basics of the education IRA and how it compares to other forms of investment for college savings.

Education IRA Basics

The Coverdell ESA is a tax-advantaged account that allows you to put money away for a child's education. You can set up the account at nearly any financial institution in the country. You fund the account with after-tax dollars, and then the earnings in the account are allowed to grow without any tax burden. Once the child is ready for college, he or she can take money out of the account without any tax implications. This sort of IRA is very similar to a Roth IRA because you pay the taxes on the money before it goes into the account. 

Benefits of an Education IRA

  • Not limited to college tuition--The funds from the Coverdell ESA can potentially be used for a variety of expenses besides college tuition. The funds can be used for books, room and board, transportation, tutoring, computers and a variety of other education expenses. You can even utilize them to pay for certain elementary and secondary education costs. This gives you a lot of flexibility in how you utilize them.
  • Corporate contributions--With this type of plan, a corporation could potentially contribute to a child's fund. For example, if you own a business and are saving for your child's education with this plan, you can contribute directly from your business. 
  • Tax advantages--One of the biggest advantages of this plan is the tax savings. If your investments do well, you could potentially save quite a bit in taxes over the years. 

Compared to 529 Plan

Another popular option for saving for education expenses is the College 529 plan. There are a few distinct differences between the two plans. For one thing, the Coverdell plan does not allow you to contribute anywhere near as much as does the 529 plan. With the Coverdell plan, you can contribute a maximum of only $2000 per year. With the 529, you could potentially contribute as much as $350,000 over the life of the plan, depending on which state you live in. It is very difficult to rely on a Coverdell as your only means of paying for college when you can contribute only $2000 per year. 

With the Coverdell, however, you have many more investment options. You can also reallocate your funds as much as you want. With a 529, you can do that only twice a year.

Compared to Savings Bonds

Savings bonds are also a popular tool for education savings. Savings bonds allow you to invest much more money for education expenses each year. However, you could potentially earn a better rate of return on your investments through the Coverdell plan than you could through a savings bond. 

Is there an education IRA early withdrawal penalty?

You may be concerned about incurring a penalty on an early education IRA withdrawal. You fund this type of account with after-tax dollars. This is similar to with a Roth IRA. Since you are funding it with after-tax dollars, you can withdraw the money that you put in at any point. The only time that you would potentially incur a penalty for taking out your money is if you take out some of the money that was earned from the investments on a tax-free basis. You can always withdraw money for education expenses without penalty.

What are the education IRA contribution limits?

If you are interested in making an education IRA contribution, you have to make sure that you stay within the annual limits. As of 2010, you can contribute as much as $2000 per year to an account. This number is not affected even if you set up more than one account for your child. If you have more than one child, you can contribute up to $2000 for each of them without penalty. If you make additional contributions, you may have to pay penalties, and you will have to take the money back out of the account.

What are the education IRA withdrawal rules?

When it comes to taking an education IRA withdrawal, you have to make sure that you follow the rules. This type of account is funded with after-tax dollars, just as a Roth IRA is. With these kinds of accounts, you can take out the principal that you put into the account at anytime without paying any type of penalty. If you need to take money out of your education IRA for education expenses, you can do so at any point without paying a penalty. If you take out money for expenses other than educational ones, you will have to pay a penalty on gains from the account that you withdraw.

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