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You know that thrill you get when pull out a jacket you haven’t worn for several months, put your hand in the pocket and pull out a forgotten $20? A co-worker just got that same delight — about 250 times over.

If you’re thinking, “That must have been the world’s biggest trench coat!” well, it wasn’t a coat. Instead, it was a Coverdell Education Savings Account that had built up a balance of several thousand dollars. If you haven’t heard about a Coverdell account, you’re not alone. After state-sponsored 529 college investment plans were introduced, Coverdell accounts faded into obscurity, and that lack of attention helps explain how my colleague temporarily lost track of his.

The Coverdell account used to be called the Education IRA, and it works quite a bit like a Roth IRA. But it can be used to cover a wider variety of expenses before college, including tutors and even required uniforms at high schools or elementary schools, making the Coverdell the Swiss Army knife of educational savings programs.

No minimum to open

Coverdell accounts have been overlooked to the point where some big mutual fund outfits — such as Fidelity and Vanguard — don’t even offer them. Most discount brokers do offer the accounts, many with no minimum to open an account.

The accounts can be opened in the name of any student younger than 18, or who is a special-needs beneficiary. The contribution limit is $2,000 a year from all sources. So if a student has accounts opened in his or her name by grandma, mom and dad and a favorite uncle, they all have to stick to the $2,000 limit, or pay a penalty. Contributions are limited to those with taxable income of $110,000 a year ($220,000 for joint filers).

As with a Roth IRA, contributions are made with after-tax dollars, so there’s no tax deduction, but gains are tax free, as long as they are withdrawn to pay qualified educational expenses. Whoever opens the account retains control of the money, which can be transferred to other children, nephews, nieces or even the beneficiary’s parents. One Coverdell account can be rolled over into another account with no limit on the amount. Once the student hits 30, however, any Coverdell money left will be distributed to him or her as taxable income, with a 10 percent penalty.

Coverdell accounts are considered a parental asset, rather than a student asset, which lessens any reduction to student aid, and withdrawals also aren’t counted as student income.

Good starting point

All of this makes a Coverdell a good starting point for educational savings. Once you max out the $2,000 limit, then you can move on to a 529 tuition savings plan, or some other strategy. By opening a Coverdell with a discount broker, parents can get a wider choice of investments than 529 plans, as well.

But, with such a low annual maximum, you’ll need to pay attention to fees. Every time you make a contribution, a withdrawal or rebalance, you could get hit with a trading fee. That means making quarterly contributions at a broker charging $9.95 per trade adds up to $40 in fees, or the equivalent of a 2 percent charge if you’re contributing the entire allowable $2,000 for the year. I’d suggest shopping for an account with a broker that offers low-cost or free index or exchange-traded funds, such as TD Ameritrade. (You can find a good list of Coverdell providers at www.savingforcollege.com.)

Come tax time, you’ll also have to pay attention to how you claim the various tuition credits and deductions, and estimate those before you withdraw cash from a Coverdell. You can’t use Coverdell money to pay expenses you’ll claim as tax deductions — that would be double-dipping, in the eyes of the IRS. But you’ve also got to keep your Coverdell withdrawals below your total educational expenses after the student’s tax-free aid and any portion you’re deducting, or any excess will be taxable to the student.

Is it worth the hassle? You get the flexibility to use the money for pre-college expenses and can transfer the money to just about any immediate relative, as well as a larger amount of investment choices than a 529 tuition savings plan.

As for the tax-free gains, if you contributed $500 a quarter to a Coverdell over 10 years, earning an average 7 percent return, you’d have a total of $28,348 for Junior or Missy to spend at State U. In a taxable account, you’d lose $2,809 of your gains to state and federal taxes. And you don’t have to go to college to do that math.

Brian O’Connor is author of the award-winning book, “The $1,000 Challenge: How One Family Slashed Its Budget Without Moving Under a Bridge or Living on Government Cheese.”

boconnor@detroitnews.com

(313) 222-2145

Twitter: @BrianOCTweet

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