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Should Coverdell Account Owners Run for Cover?

The education savings vehicle's use for precollege expenses is set to expire at the end of this year.

Adam Zoll, 09/25/2012

Question: I've been contributing to a Coverdell Education Savings Account for years to help fund my son's private elementary school tuition, but now I hear some of the tax advantages of such accounts might be going away. What's going on?

Answer: Amid all the talk about the expiring Bush tax cuts and other impending changes to the country's fiscal picture, one change that could have a dramatic impact on Coverdell accounts--and the families who use them to pay elementary and secondary school costs--has gotten little attention.

A Tax-Free Way to Save for Education
Coverdell accounts, formerly called Education IRAs, allow for tax-free growth of savings set aside for educational expenses, much like a Roth IRA for education. Currently families with modified adjusted gross incomes up to $220,000 (for those filing jointly; $110,000 for individual filers) may set aside up to $2,000 per year per child to help cover educational costs from kindergarten through college, and funds may be used for public or private schools. Contributions are not tax-deductible, but gains and qualifying distributions are tax-free. Funds may be added to the account until the student reaches age 18 and must be spent by the time he or she reaches age 30 (with special-needs beneficiaries exempt from age limits).

Advantages of Coverdell accounts include the fact that they can be used for a wide range of educational purposes and for students of various ages, but also the fact that funds can be invested in so many different ways. Unlike a 529 account, which is limited to investments chosen by the plan and which can only be used for college expenses, a Coverdell account may be invested in whichever stocks, bonds, funds, certificates of deposit, and so forth the account owner chooses.

The downside to a Coverdell is the limit on annual contributions, which, at $2,000, might not get you very far when it comes to tackling the high cost of college. In fact, while the amount of money held in 529 accounts, which have been much more widely promoted, has increased dramatically during the past decade, the amount invested in Coverdell accounts has actually declined. In 2009 (the most recent year available), just $718 million was added to Coverdell accounts, down from $1 billion four years earlier, according to figures from the Joint Committee on Taxation. Comparable numbers for 529 plans are not available, but according to the College Savings Plans Network, 529 accounts now hold around $180 billion in assets.

Originally for College Only
Education IRAs were first introduced in 1998. The idea was to allow families within given income guidelines to set money aside for college without having to pay taxes on earnings or distributions. Originally, contributions were limited to $500 per child per year. In 2001, as part of the tax cuts signed into law under President George W. Bush, use of the Education IRA was greatly expanded and the measure was redubbed the Coverdell Education Savings Account after Paul Coverdell, a U.S. senator from Georgia who had supported this expansion and who had died the year before. Among the most significant changes were an increase in the annual maximum contribution--to $2,000 per child--and the expansion of covered educational expenses to include those for students in kindergarten through 12th grade.

Fast forward a decade and here we are, with the Bush tax cuts (which were extended under President Obama two years ago) about to expire and taking the expanded Coverdell provisions with them. That means that, unless Congress and the president act, beginning in 2013 Coverdell contributions will again be limited to $500 per year, and proceeds from Coverdell accounts will again be usable only for college-related expenses. Other restrictions also will go into effect, including eliminating the age-limit exclusion for special needs beneficiaries and adding an excise tax that makes it prohibitive to contribute to both a Coverdell and a 529 account for the same beneficiary in the same year.

Wide Range of Uses for Coverdell Funds
So what happens to the money your clients have saved in a Coverdell account to pay for precollege educational expenses? Well, there's always the possibility that Congress will retain the current Coverdell rules, perhaps as part of a larger deal to extend some or all of the Bush tax cuts, but of course there are no guarantees. If your clients want to use Coverdell funds on precollege educational expenses without having to worry about paying regular income tax rates plus a 10% penalty on nonqualified distributions, they have until Dec. 31 to do so. If clients expect to pay primary or secondary school tuition or fees beyond this year, they might want to ask the school if they can prepay now in order to take advantage of the current Coverdell rules. Even if that's not an option, the good news is that there is broad latitude as to what counts as a qualified educational expense for primary and secondary school students. This includes tuition, books, supplies, tutoring services--even personal computers and Internet access (the Internal Revenue Service lists more here).

Adam Zoll is an assistant site editor with Morningstar.com


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