Easy Street Investing

Save for a kid, save on your taxes …

Nilus Mattive

Don’t worry, tax season is almost over and I’ll soon be moving on to other financial topics. But since there’s still time for you to make beneficial moves, I wanted to talk about one additional way to avoid some future taxes.

It’s a special type of tax shelter like some of the others I’ve been writing about here and here.

The difference is that this one is strictly for the kids in our lives!

It’s called a Coverdell ESA and it’s designed to help you save for the cost of a child’s education.

I’ve been using one of these accounts for my daughter since she was born in 2007, and as of April 1 she had earned a total return of 49% on the contributions I’ve made.

How These Accounts Work …

Coverdell Education Savings Accounts used to be known simply as Education IRAs, and while they’re not really “retirement” accounts, they DO function very much like Roth IRAs designed for young students.

Retirement

In fact, like Roth IRAs, they allow you to sock away money — $2,000 a year in this case — by tax day.

That means you can contribute $2,000 into a new or existing Coverdell and still count it for 2012.

And like Roth IRAs, as long as the funds are used for the benefit of schooling costs, any returns earned in the account will be distributed free of additional taxation going forward.

No, $2,000 isn’t all that much … especially with the skyrocketing cost of higher education. But it’s still a nice chunk of change that will add up over the years.

Plus, it’s perfect for using any tax refund money you might have already received if you happened to file your taxes early.

And don’t underestimate the benefit of that tax shelter:

Let’s say you happened to put $2,000 into your child’s Coverdell account and invested it so wisely that within ten years it had miraculously turned into $200,000.

That full amount would be available to pay for your kid’s education, and not one penny of taxes would need to be paid as you pulled it out!

Another cool feature of Coverdell accounts is that — unlike ever-popular 529 Plans — they can be used for expenses related to ALL types of schooling: High-priced pre-K classes, private secondary education, and even many associated costs such as computers and books.

Like the Roth IRA there are some caps to be aware of:

Technically, you cannot fund a Coverdell if you have MAGI above $110,000 filing singly or $190,000 married filing jointly. Phase-outs kick in at lower levels, too.

But here’s where it gets interesting — even a child with no earned income can contribute to a Coverdell!

So if you’re above the income threshold, you can just gift the $2,000 to the child under the Uniform Transfer to Minors Act and then they can put it in the Coverdell themselves.

And again, please note that you can establish a Coverdell for ANY child in your life — not just a direct relative but even a friend’s child or grandchild. Corporations and trusts are also free to establish Coverdells.

Just know that a Coverdell’s beneficiary can only have $2,000 contributed to his or her account in any given year. So you should always ask whether an account already exists and how much has been deposited before establishing one on your own. Contributions must also be made before the beneficiary turns 18.

A Coverdell beneficiary has to use the funds before turning age 30, or else taxes and penalties will likely be owed. However, the account can always be switched to another beneficiary before then — even if the new recipient is between ages 18 and 30!

If you’re interested in establishing a Coverdell, just check with your regular brokerage house or other financial institution. Most offer them, and it’s just a matter of completing some simple paperwork.

But remember, you only have until April 15th to open or fund one for the 2012 tax year!

Best wishes,

Nilus

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