Coverdell accounts are in limbo

(Reuters) - Coverdell college savings accounts used to be a good deal, even better than the more widely promoted 529 savings plans. But the tax breaks that made Coverdells so sweet are expiring at the end of 2010, and it's not clear whether they will return.

That means you have to figure out what to do with your account. Here's what you need to know now.

Like 529 plans, Coverdells allow you to save money tax-free for college. You can open a Coverdell at almost any bank, brokerage or mutual fund company and you can manage it yourself, so these accounts tend to give you more investment leeway than 529 plans. You don't get a deduction for your contributions, but money earned in the account is not taxed when it is withdrawn to pay for school.

For 2010, you're allowed to put $2,000 in a Coverdell account for each child. After this year, that limit drops to a measly $500, though that could get extended as part of a big tax extenders bill many expect Congress to pass at some point in the next year.

Unlike 529 plans, Coverdells allow you to withdraw the money tax free to pay for K-12 private school, too. That expires at the end of 2010, too and it's controversial enough that savvy observers don't expect it to be extended.

There's one other key difference between Coverdells and 529 plans that could emerge in 2011. Right now, you can withdraw money tax-free (from either one) to pay for college AND claim education tax credits like the Hope credit in the same year, as long as they aren't for the same expenses. So, if you paid $12,000 for tuition and books for your daughter in 2010, you could withdraw $10,000 from her Coverdell (or 529 account) and still get a Hope tax credit for the next $2,000. Next year, unless new legislation passes extending that break, you'll still be able to do that for the 529 plan, but not the Coverdell account.

That's a pretty important distinction. Put all of those new limitations together, and by 2011, Coverdells don't seem all that great. What should you do about that now?

Don't panic, says Joe Hurley, of Savingforcollege.com. Hurley is an authority on both types of accounts, and he says that you can always transfer the balance of your child's Coverdell account into a 529 plan for him or her, so there's no need to abandon the Coverdell in a hurry. You can wait to see what Congress decides to do with them and then make your own plan.

Pull money out for private school, if that's been your aim all along. If you've been stashing money in a Coverdell to pay for your child's elementary, middle or high school years, use that money now; it may be your last chance. Your child's school may allow you to prepay 2011 tuition before the end of this year.

You can buy a computer, too. If you want to use up more of your Coverdell account early, you can use it to buy your child a computer and other supplies she will use at school. If you still want to keep the college savings funds up, you can deposit a like amount into a 529 plan.

Keep feeding it. If your kids already have Coverdell accounts and you've been happy with them, there's no reason not to make contributions for 2010, says Hurley. If the Coverdell loses its big bennies, you can always move the money over to a 529 later. If those breaks get extended, your whole family will be happy you still have cash in the account.