Saving for educational expenses is an expensive proposition, and the government tried to make it easier for savers by offering a tax-favored vehicle that was initially known as an education IRA. Later, the name got changed to a Coverdell Educational Savings Account or ESA, but the idea remained the same: allow people to save on a tax-free basis for qualified educational costs. However, the problems with the education IRA mostly centered on the fact that contribution limits were small and that alternative savings vehicles became more popular. Below, we'll take a closer look at the historical evolution of the education IRA and why it has never truly caught on among investors.
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The origins of the education IRA
Education IRAs were created in 1997 as part of a broader set of tax reforms to offer a new set of incentives for education. The tax legislation also included the creation of the Hope Scholarship tax credit, the lifetime learning credit, and the student loan interest deduction, as well as expanding the eligible educational expenses for which 529 plan withdrawals could be used.
At the time, though, the education IRA wasn't given much power to help people save. Contribution limits were just $500 per year, making them relatively unattractive not just for savers but also for the financial institutions tasked with helping accountholders set them up. In 2001, lawmakers expanded education IRAs, renaming them Coverdell ESAs and increasing the maximum annual contribution to $2,000. But even then, those numbers were relatively small compared to the primary alternative that most savers were using: 529 plans.
Why 529 plans got more popular
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At first glance, you'd think that education IRAs would have been the better choice among savers. They offer much more flexibility in choosing investments, in contrast to the fixed menus of investment options that restrict 529 plans. In addition, education IRAs are available for educational expenses not just in college and beyond but also for kindergarten through high school.
However, 529 plans had one key advantage: they allowed families with financial means to put much larger contributions to work. Families can contribute as much as they want to 529 plans, subject only to the lifetime limits that each plan sets. Most of those limits are roughly in the $200,000 and $400,000, which makes the $2,000 annual contribution limit on Education IRAs look puny by comparison for the well-to-do. Indeed, because taxpayers with modified adjusted gross incomes above $110,000 for single filers or $220,000 for joint filers aren't allowed to make Education IRA contributions at all, 529 plans became the only choice for those most able to commit large amounts toward college educational expenses.
In addition, many people actually found the more limited selection of investments in 529 plans to be helpful. In particular, many 529 plans offer portfolios that automatically adjust as a child grows toward college age, starting out more aggressively in the child's youngest years but then becoming more conservatively invested as the date on which the money will be needed to pay for college approaches. Education IRA investors, on the other hand, have to manage their own money, and few financial institutions offer the same custom-made investment products that 529 plans have.
Why the education IRA is almost gone
Nowadays, not all financial institutions even allow you to open a new education IRA at all. Major companies like Fidelity and Vanguard simply don't offer the accounts any longer, having apparently judged that the relatively small amounts of money involved don't make them worth their time.
That said, you can still find education IRAs at some major brokers. Schwab, TD Ameritrade, Scottrade, and E*Trade are just some of the brokerage companies where you can open a Coverdell ESA and start saving for education on a tax-free basis.
Most investors will find that 529 plans are a more useful way to save for college expenses. However, education IRAs offer the added flexibility in investing options and allow you to use account money for pre-college educational expenses. For many, that makes looking at education IRAs -- under their new name of Coverdell ESA -- a worthwhile effort.
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