The Education Savings Account You Never Hear About

Group of students in the classroom

As a tool for college savings, options like 529 plans offer some impressive tax breaks to help savers cover college expenses. But they're not the only game in town.

If you want the added flexibility of being able to cover educational expenses before your children even reach college, one choice stands above the rest: the Coverdell Education Savings Account, named after the Georgia senator who sponsored the legislation that created the accounts.

What ESAs Have That College Savings Plans Don't

Most of the tax incentives available both for educational expenses and for savings plans tied to education focus exclusively on college expenses.

  • The American Opportunity Tax Credit offers up to $2,500 annually for students in their first four years of college.

  • The Lifetime Learning Credit provides as much as $2,000 per year in tax credits for advanced learning, whether it be for additional undergraduate studies, graduate programs, or further education later in life.

  • 529 plan accounts allow assets to earn income on a tax-free basis, with accountholders never paying tax as long as withdrawals are used for qualified college expenses, including tuition, room and board, and ancillary expenses like books and required course materials.

But unlike those other options, the education savings account allows parents more flexibility to use account assets for a broader range of educational expenses. Specifically, the education savings account is unique in allowing tax-free treatment for money used for qualifying expenses from kindergarten through 12th grade.

Those who send their children to public school might figure that there's little reason to have an education savings account, as they generally won't owe tuition and fees or room and board for their children's studies. But ESAs also allow tax-free distributions for books, supplies, equipment and academic tutoring services. In addition, costs of transportation such as busing are eligible, as are purchases of computers, Internet access and related technology services as long as the student will use those items during their education.

Why Aren't Education Savings Accounts More Popular?

According to the most recent figures available, less than $1 billion was invested in education savings accounts as of five years ago, and ESAs have become so small that overall asset statistics haven't been updated since then. For comparison, the Investment Company Institute reports that as of the end of 2013, 11.6 million 529 plan accounts held more than $227 billion in assets. There are several reasons why education savings accounts haven't become more popular:

  • Contribution limits are extremely low compared to 529 plans, with ESAs permitting only a maximum of $2,000 per year. Moreover, income limits restrict some higher-income taxpayers from contributing to ESAs, with single filers earning more than $110,000 and joint filers with income above $220,000 not allowed to establish or add money to education savings accounts.

  • Rules governing unused ESA funds are stricter than for 529 plans. Assets in an education savings account that aren't used by the time the child reaches age 30 must be distributed, with taxes and a 10 percent penalty applying since the distribution isn't used for qualifying educational expenses. Although some options for transfer to another qualifying beneficiary under age 30 exist, they aren't as flexible as alternatives for 529 plan account owners.

  • Because the laws governing education savings accounts require financial institutions to act as custodians for the assets -- much like a retirement account -- many institutions have chosen not to offer accounts to customers. Major fund companies including Vanguard and T. Rowe Price used to have ESAs as options for investors, but they've stopped accepting new account applications. Fidelity never bothered accepting ESA accounts in the first place.

Take a Closer Look

Even with these limitations, education savings accounts can be a useful tool for expenses before your child graduates from high school. If you anticipate having substantial school expenses prior to college, then it's worth taking a closer look to see if an ESA would give you benefits that a 529 plan or other college-saving option can't deliver.

You can follow Motley Fool contributor Dan Caplinger on Twitter @DanCaplinger or on Google+.