Opening a Coverdell May Require Shopping Around

Note: This article is part of Morningstar's October 2013 College-Savings Boot Camp special report. This article originally appeared May 21. 

Question: I'd like to open a Coverdell account for my child, but my fund company doesn't offer them. How do I go about getting one?

Answer: A Coverdell Education Savings Account can be a great way to save for educational expenses, especially for families with precollege costs. A Coverdell is similar to a Roth IRA in that contributions grow tax-free and distributions are also tax-free if used for qualified educational expenses. (For details on which expenses are covered, see this Internal Revenue Service document.)

Coverdell accounts are often mentioned alongside 529 college-savings plans in that both offer tax-advantaged ways to save for education. But there are some key differences. Most significantly, even though both account types can be used to cover college costs, the Coverdell also can be used for expenses from kindergarten through 12th grade. That's a big plus for families sending their kids to private elementary or high schools, or who are paying for tutoring or other educational services out-of-pocket. Also, unlike 529 plans, which offer a set menu investment portfolios based on mutual funds, with a Coverdell, investors get to choose whichever mutual funds, exchange-traded funds, stocks, and bonds they prefer.

Along with these advantages, however, come some drawbacks. One is that annual Coverdell contributions are limited to $2,000 per beneficiary, which limits the account's value as an educational savings vehicle. Also, Coverdell contributions may only be made by those with modified adjusted gross incomes of less than $110,000 if single, or of less than $220,000 if filing jointly. Finally, 529 contributions are often deductible on your state tax return, whereas Coverdell contributions are not.

Despite these drawbacks, Coverdells can be an attractive option for families looking for a way to save for a broader range of educational costs and use a wider array of investment options than a 529 can provide. Plus, there's no reason they can't utilize both account types--for example, using a Coverdell for K-12 expenses and a 529 for college expenses.

Account Benefits Extended
Although some investors may have been hesitant to open Coverdell accounts in recent years because of their uncertain future, that black cloud was lifted by the fiscal cliff deal struck by Congress earlier this year.The accounts were originally expanded as part of the Bush tax cuts in 2001, but those provisions were set to expire at the end of 2012. Had that happened, the accounts would have reverted to the original rules, covering college expenses only and with annual contribution limits of just $500, making them of little use given the much higher contribution amounts possible through 529 plans. Now the expanded Coverdell rules have been made permanent, allowing for the accounts to remain a viable option in investors' educational savings toolkits.

Options Include Brokerages, Some Fund Companies
As your question suggests, opening a Coverdell account could be a problem for some investors because not all fund companies offer them. Fidelity doesn't, and  T. Rowe Price Group (TROW) stopped accepting new assets into its Coverdell accounts last year. Vanguard allows contributions to existing Coverdell accounts but doesn't allow investors to open new ones. Other fund companies do still allow investors to open Coverdells, however, including American Funds, Franklin Templeton, Oakmark, and JP Morgan. Opening a Coverdell account through a fund company could mean paying loads or account fees, however.

Another option is to open a Coverdell through a brokerage.  Charles Schwab (SCHW), E*Trade Financial ,  TD Ameritrade , Scottrade, and Merrill Edge (formerly Merrill Lynch) all offer Coverdell accounts and allow investors to capitalize on one of the account type's main advantages: the freedom to build a tax-advantaged investment portfolio using whichever funds, ETFs, stocks, and bonds the account holder prefers. But as appealing as that may sound, there are potential shortcomings to this strategy. Although fund companies typically allow customers to make contributions whenever they please at no cost, a brokerage typically charges per transaction. That means that any time you make a contribution to the Coverdell through a brokerage, you may be required to pay trading fees.

For example, let's say you want to use Vanguard ETFs in your Coverdell account, but rather than investing in one lump sum, you prefer to use dollar-cost averaging by diverting a set amount from your paycheck each month. Now let's say the brokerage charges $10 per trade for ETFs. That means you'd be adding $120 per year in expenses to the cost of maintaining an account to which you can only contribute a maximum of $2,000. (Some brokerages offer commission-free trades for some ETFs, but this will limit your choices.)

So, even though one advantage Coverdell accounts have over 529 plans is freedom of choice, you could end up paying more for access to a wider variety of investment options. Before opening a Coverdell, make sure you understand any extra costs involved. Saving for education is a great idea, but you shouldn't have to pay an arm and a leg to do it. 

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