Pros and Cons of ESAs

Once you get an idea of what it will cost you to send your children to college or, in some cases, private school before they even get to college, you may decide that Coverdell Education Savings Accounts (ESAs) are the way to go for investing for the kiddies' educations. Before you make that decision, let's walk through the pros as well as the cons of using ESAs when investing for education.

Let's go over the bad news first. The first con is really a catch-22 situation: you may not be eligible to contribute to an ESA because your adjusted gross income is too high. Obviously this is only a con in that ESAs aren't available to you as an investment vehicle--exceeding the income limits means it's likely things are going pretty well for you financially.

Example If you find yourself in a position where you exceed the income limits for contributing to an ESA, you may want to consider encouraging close relatives and friends who you believe to be eligible to forgo the expensive gifts at birthdays and holidays and fund an ESA for your children instead. If you suggest it tactfully, those close to your children would probably be happy to spend their money on building an education fund rather than the latest broken in an hour fad toy on the market.

The second downside to using ESAs for educational investing is that the limit contributed annually for each beneficiary is maxed out at $2,000. However, how much of a downside this limit is depends on when you start investing. For example, if you start funding an ESA for your child the year they are born as opposed to when they are ten years old, the results you achieve with your $2,000 annual investment are drastically different.

Depending on when you start investing, due to the miracle of compounding of interest, your $2,000 investment can grow to quite a formidable sum if given the time. If you start contributing annually to an ESA sooner rather than later, depending on your child's individual education plans, you will probably find yourself in pretty good shape. This is especially true if you were able to put money into other education investment vehicles as well.

Warning Investing in an ESA may limit or eliminate otherwise available financial aid, as well as tax breaks for education expenses. For example, for purposes of calculating the amount of financial aid a student is entitled to, ESAs are considered to be the student's assets. Therefore, an ESA is given more weight when calculating the expected family contribution toward education, resulting in less aid.

Tax advantages. How about the upside of ESAs? The main advantages of ESAs are tax advantages. There is no taxation of current earnings and tax-free distributions of contributions and earnings as long as they are used for qualified education expenses. Anyone can contribute to an ESA for a beneficiary (other than those subject to the income limitations). The contributor to an ESA, usually a parent or grandparent, also has the advantage of making decisions on where and how his contributions are invested. The contributor opens the account at a place of their choosing and can choose to be involved with the choice of investments made with her funds. This freedom isn't available to the same extent for certain other educational investment vehicles, such as state tuition plans.

Qualified expenses. Another advantage that only ESAs have when you talk about investments specifically set up for education expenses is that funds from ESAs can be used for qualified expenses in the elementary, middle and high school years. If you start contributing to an ESA early enough, you will have a nice nest egg built up to put toward the rising costs associated with education in the pre-college years, including tuition, uniforms, etc.