Chances are you're familiar with the highlights of the ironically titled American Taxpayer Relief Act (ATRA), signed into law on January 2. The law returned payroll taxes to their previous higher levels and raised rates for high earners, among (many) other things.

While many of the new law's provisions (especially the negative ones) received wide publicity, buried in the details was a nugget for college savers. In recent years, "529" plans have become the default choice for tax-advantaged college savings. But the ATRA has breathed new life into their primary competitor, the Coverdell Education Savings Account (ESA). (Visit Savingforcollege.com to easily compare 529 Plans to Coverdell Education Savings Accounts.)

What the ATRA did was make most of the Coverdell provisions permanent. Since 2001, Coverdells have lived with the threat of "sunset" over their heads. Under previous law, the maximum contribution for Coverdell ESAs would have been lowered to only $500 a year. Such a change, of course, would have greatly reduced the usefulness of Coverdells as a college-savings vehicle.

What Is A Coverdell ESA?

Created in 1997 as "Education IRAs" and improved dramatically in 2001, Coverdell ESAs (named for the late Sen. Paul Coverdell of Georgia) are a compelling savings vehicle for parents whose income falls below the law's income limits. Parents with an adjusted gross income below $190,000 (filing jointly) may contribute up to $2,000 per child, per year, to a Coverdell ESA. (The contribution ceiling is gradually lowered for taxpayers with modified adjusted gross incomes between $190,000 and $220,000; those with incomes over $220,000 may not contribute to a Coverdell ESA. Limits are $95,000 and $110,000 respectively for single filers.) Coverdell contributions aren't deductible, but all earnings grow tax-deferred and can be withdrawn tax-free if used to pay the student's college expenses.

Furthermore, anyone (grandparents, other relatives, friends) can contribute to your child's Coverdell account as long as they meet the income-eligibility rules; however, the total contribution from all sources can't be more than $2,000 a year. (It's possible to set up multiple Coverdell ESAs for the same child, but there's not much point because, again, the total contribution—for all accounts taken together—is capped at $2,000.) A scant $2,000 per year may not seem like much when college costs run into the tens of thousands per year, but a steady stream of $2,000 contributions can add up—if you start early. Assuming an annual earnings rate of 8%, $2,000 per year would accumulate to more than $70,000 over 18 years.

Why Coverdell ESAs Are A Big Deal

Coverdells have two significant advantages over 529 plans. First, they allow you the flexibility to choose the specific investments you desire. This is important for those who want to direct their own investment program, as many SMI members prefer to do. Most fund companies or brokerages can set up a Coverdell ESA for you, allowing access to their full range of investment products.

This means you not only can pursue a passive index-fund strategy such as Just-the-Basics but a more aggressive active strategy such as Fund Upgrading if you choose. (Most 529 plans offer index-fund options, which you can use to roughly duplicate our Just-the-Basics strategy, but their limited menu of funds beyond that makes Upgrading impossible.) While Upgrading's recent performance has been similar to JtB, its longer-term performance has been superior. Ten years ago, if you had $10,000 in a Coverdell ESA and had Upgraded with it, you'd have $30,691 today, even if no new money was added. If the same amount had been invested using Just-the-Basics, you would have $27,187. That's a noticeable difference.