Families interested in opening a Coverdell Education Savings Account this year for college savings should consider doing so before April 15. That would allow them to invest as much as $4,000 in one of these tax-advantaged accounts this year—twice the maximum for annual contributions—since money deposited before April 15 can be counted against the previous year's limit.
But families planning to use a Coverdell account to pay for pre-college education expenses should think twice about opening or contributing to an account this year. Starting next year, withdrawals from Coverdells to pay expenses from kindergarten through 12th grade will no longer be tax-free, unless Congress acts to extend that benefit, which is far from certain.
Another prospective rule change would lower the limit on annual contributions to $500 starting next year, making Coverdells less useful for college savings. Already, the $2,000 limit has made Coverdells much less popular than 529 college-savings plans, which offer similar tax benefits for college costs and a roughly $300,000 limit on contributions overall. But even some people who are putting away more than $2,000 a year for college have included Coverdells in their savings plans, because Coverdells offer a greater range of investment options than 529 plans, and more freedom to switch investments.
Another benefit that could expire at year's end is the ability of an investor to claim a Hope or Lifetime Learning tax credit for education in the same year they use Coverdell funds, as long as the tax credit and Coverdell money aren't used for the same expense. For example, an investor can take a tax credit for tuition in the same year s/he is using Coverdell money for books. This benefit is scheduled to sunset at the end of this year, resulting in the two tax benefits becoming mutually exclusive.
A 2001 tax law expanded Coverdells to cover not just college but also K-12 expenses for public or private education. Covered expenses include tuition, academic tutoring, special-needs services, extended-day programs, books, computers, equipment, room and board, uniforms and transportation. Senator Chuck Grassley, an Iowa Republican, who is the ranking minority member of the Senate Finance Committee, has introduced legislation that would prevent the K-12 provision from expiring at year's end. The measure also would preserve certain tax benefits of Coverdells and keep the annual contribution cap from dropping back to $500. But the legislation's prospects are uncertain.
A 2001 tax law expanded Coverdells to cover not just college but also K-12 expenses for public or private education. Covered expenses include tuition, academic tutoring, special-needs services, extended-day programs, books, computers, equipment, room and board, uniforms and transportation. Senator Chuck Grassley, an Iowa Republican, who is the ranking minority member of the Senate Finance Committee, has introduced legislation that would prevent the K-12 provision from expiring at year's end. The measure also would preserve certain tax benefits of Coverdells and keep the annual contribution cap from dropping back to $500. But the legislation's prospects are uncertain.
Given the uncertainty, families may want to consider either spending Coverdell accounts on K-12 expenses before the end of the year, or just accepting that the funds will have to be expended for college expenses later. Investors can also consider moving funds in Coverdell accounts to 529 accounts, which is permissible without triggering tax penalties. That might make sense if the rules expire that currently allow people to use Coverdell funds and claim Hope or Lifetime Learning credits in the same year. Investors in 529 accounts have that same right, and it isn't at risk of changing.
Whatever their situation, families should not only be aware of the possible rule changes but also be sure they understand exactly how Coverdells work.
Financial Benefits of Coverdells
Coverdells offer tax-free investment growth and withdrawals as long as the money is used for qualified expenses. They used to be called education IRAs—before being renamed for the late Sen. Paul Coverdell, a longtime supporter—and sometimes are still referred to as such. But that label may be misleading, since, unlike money invested in a traditional individual retirement account, contributions to a Coverdell account cannot be deducted from taxable income.
Many financial firms offer Coverdells without any annual fees, and investors can choose low-cost investments such as index mutual funds and exchange-traded funds.
Contributors must have modified adjusted gross income below $110,000 for an individual or $220,000 for those filing joint tax returns. But only those with modified adjusted gross income below $95,000 for an individual and $190,000 for joint filers can make the maximum annual contribution of $2,000; above those income levels, the maximum gradually shrinks to zero.
There is a way around the income limits, though, because a child can make his or her own contributions to a Coverdell account, using money received as a gift from parents or anyone else. The financial institution offering the account generally will require a parent or guardian to sign on as a "responsible individual." For a dependent student, the impact on financial aid is the same as if the contributions were made in a parent's name. For more information please consider the website savingforcollege.com.
In any case, the annual maximum for contributions is per child. So if two or more relatives, for instance, are contributing to different Coverdell accounts for the same child, the total of those contributions can't exceed the annual maximum.
Coverdell account beneficiaries must be under age 18 when the money is contributed, and the money can be used only for the beneficiary. The money can't be refunded to the person who starts the account. If the beneficiary turns 30 and the money remains unused, it will be distributed to him or her and will generally be taxable. (The age limits don't apply to special-needs students.) The person who started the account also has the option to change the beneficiary at any time to a different family member under age 30.
Coverdell contributors can pick their own investments; the only investment not allowed by law is life insurance. In contrast, investors in 529 plans can choose only from a set menu of investment options.
The financial institutions that offer Coverdell accounts can, however, restrict the types of investments they allow. Many institutions, for example, prohibit risky investments like art, antiques and coins.
Investors in Coverdells can switch investments as many times as they want. In 529 plans, investors can make changes only once a year. Switching too often can be costly, though. Investors should be aware of commissions or other fees associated with buying or selling investments.
Investors should also think carefully about any fees charged by firms to set up or maintain a Coverdell account. With such low contribution limits, even a yearly fee of $25, for instance, might not be an insignificant portion of any investment gains.
If you have questions, please see your financial planner or estate planning lawyer.
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