Coverdell Contributions

In a special midweek edition of the Tax Forum, we discuss the shortcomings of the Coverdell Education IRA and some changes to student-loan interest rates. But first:

Got year-end tax questions? I wasn't too high on the Education IRA the first time we wrote about it back in May. Granted, the ability to withdraw savings tax-free for education is appealing, even if you can contribute only $500 a year to the account.

But now that we found it could saddle the poor student's account with a tax liability, I'm even more convinced there are better ways to save for college. The problem: Anyone can open an Education IRA for a child without notifying the parent or legal guardian. So parents have no idea how much money is out there in their kid's name. The law limits annual contributions on behalf of a child to $500 and slaps a 6% penalty on amounts above that.

Granted, the IRS has recently "recommended" that you notify parents if you're opening an Education IRA, says Kathryn Jordan, assistant vice president of retirement plans marketing at Aim Management, which just started offering an Education IRA this week. But that ruling's not legally binding. And not every issuer of these IRAs is requiring notification.

"Our involvement in the tax liability is limited," says the spokeswoman at Stein Roe Mutual Funds. If Grandpa wants to open an account for Jimmy, Stein Roe doesn't require that he tell the kid's parents. So let's say your three long-lost aunts decide that, because their adjusted gross incomes are below $95,000 ($150,000 if they're still married), they're each going to put $500 in an account for little Jimmy. Not only do they not inform each other, but the law does not require that they inform Jimmy's parents. So they don't.

Now Jimmy has $1,500 in Education IRAs in his name. But he's only allowed to have $500, according to the rules of the Education IRA. If two of your aunts take their money out of the accounts before their tax returns are due, everything will be OK. (Your aunts will owe tax on any earnings the money generated, though.)

And if they don't get the money out in time? The excess contributions will be subject to a 6% penalty each year they are held in the account, according to Section 4973 of the tax code. But if family members don't often speak to one another, how would you know your kid had too many contributions in his name?

The fund company does file a contribution form with the IRS bearing the child's social security number. In a perfect world, the IRS would realize it's gotten a bunch of forms noting contributions on behalf of the same social security number. But odds are it'll fill you in a few years too late. Some fund families like Aim and T. Rowe Price are heeding the IRS' recommendation and requiring a parent's or guardian's signature before anyone can make a contribution. But otherwise you're on your own.

"It's like they created a land mine and lured small children" to step on it, says Bill Fleming, director of personal financial services for PricewaterhouseCoopers.

Education IRA