« »

Thursday, August 15, 2013

Sources of college funding: The little-known alternative to a Coverdell ESA

By Jenni Wiltz

College Fund
Life insurance is a college savings instrument
Between 2000 and 2011, college expenses at public schools (including room, board, and tuition) rose 42 percent. That’s according to the National Center for Education Statistics, which also reports that a single year of undergrad expenses at a public college will set you back $13,600. If you’re wondering how to help your child deal with these astronomical costs, you might have looked into Coverdell educational savings accounts.

Coverdell accounts are special educational savings vehicles that help you sock away money for your child's educational expenses. You might hear them compared to 529 plans, to which they’re quite similar. But are they the best idea in terms of a savings plan? Is there a way to make your money work harder for you?

What tou get with a Coverdell ESA

According to the IRS, Coverdell accounts allow you to deposit up to $2,000 yearly into an account where your child is the beneficiary. You have investment options to help that contribution grow. Stocks, mutual funds, and CDs are all common choices. You can’t deduct your contributions on your taxes, but the government is giving you a bit of a break. The money in your Coverdell account will grow tax-free until your child needs it. As long as the total sum of what you take out is less than your child’s overall qualified educational expenses, he or she won’t pay a dime of tax.

What you don’t get with a Coverdell ESA

Because this money is in a government account, you have to abide by the government’s approved list of educational expenses. The IRS code stipulates that college students, for example, cannot use this money for transportation expenses (although transportation expenses are allowed for primary and secondary school students). They also cannot use it for computers or software, unless those items are required by the college. Since most colleges offer computer labs, these items are rarely required.

There’s another consideration. What happens if your student drops out…or decides not to go to college at all? If life takes them in a different path, what happens to all that money? To avoid any IRS taxes or penalties, you can roll one child's Coverdell account over to another child. If the account still has money in it when your child reaches age 30, it will need to be distributed to close the account. At that point, the money that account has earned in interest is taxable, plus subject to a 10% penalty.

Is there another option?

Other than 529s, which have many of the same limitations, you have another option. Permanent life insurance policies are a little-known way that parents are saving for tuition, providing a future inheritance for their kids, and subsidizing their own retirement, all at the same time.

Permanent life insurance policies build cash value over time. A portion of every payment you make is put into your cash value account. Depending on the type of account you have and your insurer, your options range from slow and steady interest-based growth to the risk (and potential gains) from market indexes. Like a Coverdell or 529 plan, your money grows tax-deferred.

When you pull out that cash value, you can take up the amount you’ve already contributed in premium payments, absolutely tax-free. That cash can be used for anything. You can give it to your student to pay for tuition, room & board, transportation expenses, or a computer. You can send them off with a new laptop, or a used car so they can come home to see you once in a while. You can’t do either of those things with Coverdell money.

There’s another advantage, too. What if your child drops out of college…or decides not to go at all? With cash value, you can then redirect that money to travel, starting a new business, or just use it to supplement your retirement. It allows you to support your children...and yourself...based on your needs now, not what you thought your needs were 10 or 15 years ago. If you need to repurpose the money in a Coverdell account, be prepared to pay tax on the gains as well as an extra 10% penalty.

Overall, permanent life insurance’s cash value gives you more flexibility to support your family in any endeavor they choose.

About the author: Jenni Wiltz blogs about insurance, finance, and retirement planning for WholesaleInsurance.net.
* Image license: Creative Commons image source