Explore Pros, Cons of Using Coverdell Accounts for College Savings

For parents preparing to send their child to college, the total educational costs they may be facing can be overwhelming, as can the available options to save for them. But while parents have the choice to stash their cash in everything from traditional savings accounts to the stock market, the most attractive options are typically those that provide the most financial benefit for the investor.

Coverdell Education Savings Accounts are similar to IRAs, in that they allow account holders to make contributions to an investment account. And like 529 plans, Coverdells provide an opportunity for parents to achieve tax-free growth on their investments, with tax-free withdrawals as long as the funds are used for qualified educational expenses.

Additionally, when the Coverdell is in the name of the parent -- or anyone else other than the beneficiary -- the funds within are not considered the child's and thus don't affect the student's financial aid eligibility.

[Weigh Coverdell accounts and IRAs for college savings flexibility.]

Those advantages certainly create an attractive option for parents, but as with any potential investment, there are benefits and drawbacks.

Pro: Investment options are more numerous. Parents who use 529 plans , another type of tax-advantaged savings vehicle for college, are limited in how they can invest. Because of the way plans are structured, parents are only able to invest in funds within the 529 that are offered by the plan. In a Coverdell, however, there are no such restrictions. Parents can choose to invest in real estate, precious metals, the stock market or any other asset class, except for life insurance, that could potentially have a great impact on the growth of their account.

Joshua Sheats, a Florida-based certified financial planner and host of the Radical Personal Finance podcast, gives an example of a parent with investment expertise in a specific speculative market, such as bio-tech stocks.

"If you have a new baby and you can invest a small amount of money in cheap stocks hoping for a company to discover the next miracle cure, you have the potential to grow a small amount of money into a huge amount of money," he says. "The potential here is much greater than the likelihood of a large-cap index fund in a 529 increasing at a massive rate of return."

Pro: Funds can be used for K-12 expenses. For parents saving primarily for their child's college education, paying for home schooling or private school costs at the elementary through high school levels may not be of major concern. But if the beneficiary of the Coverdell needs to be changed -- when, for example, the first beneficiary decides not to attend college -- these additional ways families may be able to use the money can be beneficial.

"This flexibility is important for parents that anticipate education costs outside of university/college or post secondary education," says Chris Nicholson , of the online investment manager FutureAdvisor. "Some parents want to send their children to private high schools, which are very expensive."

[Find out if you can afford to send your child to private school.]

Con: There are age limits for beneficiaries. All funds in a Coverdell ESA must be disbursed to the beneficiary before he or she turns 30, which could be a problem if the child decides to take some time off from college or hopes to use the funds for graduate school. If the funds are not removed from the account, they will be forced out and a 10 percent penalty, as well as income tax, will be due.

But, says Sheats, there are ways for parents to work around this situation. First, as mentioned previously, the beneficiary can be changed to another family member, provided the relative is also under age 30 -- that is, unless the relative has special needs, in which case age is not a factor. Or, the funds can be distributed into a 529 plan.

"Transferring the funds from a Coverdell to a 529 is always a qualified distribution -- thus no income tax or penalty tax is due," says Sheats, "and it is an easy way to avoid the age restrictions. Parents can then keep the beneficiary the same or simply change the beneficiary to a different person under the 529 rules."

Con: There are yearly and income-based contribution limits. While the investment options within Coverdell ESAs are virtually unlimited, the amount that can be invested is not. Parents are only allowed to invest up to $2,000 per year, per beneficiary, and that contribution limit is lower if parents make more than a certain amount in income.

For a married couple filing a joint tax return, the contribution limit begins to drop after they reach $190,000 in income, and it is reduced all the way to zero if they earn $220,000 a year, says Neil Maxwell, founder and CEO of Maxwell Wealth Planning in Colorado. "For example, if the couple makes $205,000, which is the midpoint of the phase out , then they would only be able to contribute up to $1,000 per eligible child."

Additionally, all contributions to the account must be made before the beneficiary turns 18.

[Learn three ways to make the most of a late start on college savings.]

With these restrictions in place, it may be difficult, though not impossible, for parents to achieve the amount of growth necessary to cover ever-increasing college costs through Coverdell accounts alone.

"If a parent were to save $2,000 per year from the time each of his children was zero to 17 years old, he still probably won't have put a dent in the cost of a college education," Maxwell says. "The benefits of Coverdells are still great, but they may not be large enough to really help as much as parents may need."

Trying to save for college? Get tips and more in the U.S. News College Savings 101 center.