Coverdell ESAs

Want to lay a nest egg that'll grow tax-free? Every cent you save for your child's college education is eligible for protection from the IRS! The dollars you save now could keep pace with the rising cost of tuition.

How to get it

Coverdell Education Savings Accounts (or ESAs) provide another way of supplementing the family's school budget. Formerly known as Education IRAs, these investment accounts allow students to make tax-free withdrawals for school-related expenses. Tuition, room, board, fees and supplies all qualify as legitimate expenditures.

Anyone can make deposits to the ESA as long as they earn less than $110,000 a year (for single filers) or $220,000 (for joint filers). That includes parents, siblings, distant cousins, family friends, and even complete strangers (hey, it could happen). There's no limit to the number of contributors to the pot. However, there's also a cap to how much goes into the fund each year, regardless of how many people donate. The contributions aren't tax deductible either.

Where Can I Start?

ESA are available through banks, mutual fund houses and other brokerages/institutions. As with all investments, it's best to consult with your financial advisor before opening an account.

Besides creating a tax shelter for education savings, the ESA also gives families the flexibility to choose which individual assets to invest in. Whether it's stocks, bonds or cash, it's up to the family and beneficiary to decide how aggressive they want to be with their investment. Recent legislation also allows beneficiaries to use ESA funds to pay for elementary and high schools, not just colleges and universities. It doesn't matter if the institutions are public or private.

How to get it

One drawback of an ESA is that it could penalize students applying for financial aid. Assets held under a child's name count more against a student than funds that are owned by a student's parents. Families who are expecting need-based assistance from schools and government programs should weigh their options carefully before opening this kind of account.

Another drawback? The beneficiary of an ESA must use all the funds or move them into the rollover account of an immediate family member (includes first cousins) before turning 30. Otherwise, the remaining assets are subject to heavy taxation and other penalties.

ESAs versus 529s

The ESA and 529 savings accounts are both effective tax shelters, but which one is the best for you? You can't contribute nearly as much to an ESA; a 529's "ceiling" can dwarf an ESA's by several hundred thousand dollars. There aren't any income restrictions on a 529's contributors, either. However, 529s don't provide the same flexibility and control. Once you decide the allocation of your assets, you can't make changes to your plan for 12 months. 529 plans are also subject to a fund manager's "handling fee" and other charges that could dampen the rate of your return.