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Education Savings Accounts

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An ESA may sound like something invented by NASA, but actually it's a simple way to build up tax-free college savings.

An Education Savings Account (ESA) offers investment options, tax-free earnings, and can be used to pay for a wide range of education expenses. It is worth consideration as part of your college saving strategy.

What Is an Education Savings Account?

An ESA is a tax-advantaged account that helps families save money for a child's education. Technically, the student owns the assets in the account, but since the student is a minor, the account owner acts on his or her behalf. There is no tax on earnings if the money is used to pay for the qualified education expenses of the student. ESA funds can be invested in any vehicle except life insurance.

Start an ESA Well Before a Student Turns 18

The beneficiary must be under 18 when the account is opened. In fact, no further contributions are allowed after age 18. ESAs should not be a last-minute method of paying for college. The sooner an account is opened, the better.

Contributions Are Limited to $2,000 a Year

Annual deposits over $2,000 incur a 6 percent tax. But if an ESA is set up many years before college starts, the maximum $2,000 annual investment can earn a high return over time, especially since all interest is potentially tax-free.

ESA Money Can Cover Most College Expenses

Eligible expenses include tuition, room and board, books, and required technology. An ESA can also pay for similar expenses at the student's elementary or secondary school. These expenses should not be already covered by other tax-free aid or savings. And the education expenses should not have been already used to qualify for an education tax credit.

ESAs Don't Count Heavily in Financial Aid Calculations

ESAs belonging to parents or dependent students are counted as parental assets.Parental assets have a much smaller impact on financial aid eligibility than student assets. Withdrawals from ESAs are not reported as student or parent income as long as they are used for qualified expenses.

Income Limits Define Who Can Contribute—and How Much

Your eligibility to contribute to an ESA depends on your income. You must earn less than $220,000 (if filing jointly) or $110,000 (if filing single). The amount you are allowed to contribute also depends on your income level. Joint filers making less than $190,000 or single filers making less than $95,000 may contribute the maximum $2,000 per year, per student to an ESA. Joint filers who make $190,000–$220,000 (or single filers who make $95,000–$110,000) are allowed to contribute lower amounts, depending on their income. Those with incomes too high to qualify for an ESA can open an account in their child's name.

What Else Should You Know?

When the student turns 18, he or she can take control of the funds. However, for maximum financial aid benefits, the account is best left in the parent's name. Exceptions are made for students with special needs.

If the beneficiary does not go to college, the money cannot revert to the account owner. Beneficiary status may be transferred to another family member.

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