Many families are familiar with the popular 529 plan for tax-free college saving. But whatever happened to the 529’s poor relation, the Coverdell Education Savings Account?
Well, after being shunned for years, Coverdells have been getting some respect. It’s simpler to shop for a Coverdell, the investment options are wider and the proceeds can be used for K-12 education, not just college and grad school. As with a 529 plan, a Coverdell’s investment gains can be withdrawn tax free for an approved education expense, such as tuition.
“Coverdell accounts are useful for those who are saving for private tuition and other costs associated with elementary and secondary school, since 529 plans can’t be used for those expenses,” says Jamie Canup, a tax attorney the Hirschler Fleischer law firm in Richmond, Virginia.
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Coverdells have been around since 1998, when they were called Education IRAs, but they weren’t very popular because initially there was a $500 limit on annual contributions, and the tax breaks were uncertain, needing constant renewal by Congress. That changed when the American Taxpayer Relief Act of 2012 made the rules permanent.
So now the Coverdell’s only serious drawback is the $2,000 limit on annual contributions. Rules for 529 plans vary by state, but there typically is no annual limit, and lifetime limits are in the hundreds of thousands of dollars, making the 529 the clear choice for those who want to sock away large sums.
While anyone, no matter how wealthy, can contribute to a 529, Coverdells have do have an income test. To make the maximum $2,000 contribution, an individual must have a modified adjust gross income of $95,000 or less, a couple $190,000 or less. The maximum contribution is gradually reduced as income rises, reaching zero for individuals earning $110,000 or more, and couples earning $220,000 or more.
However, people with incomes that are too high can give the cash to the child or other individual who meets the income test, and then have it directed to the account.
“If a family has $2,000 or less each year to set aside for education for a loved one, (Coverdells) are a great choice,” says LeAnn Luna, professor of accounting at Haslam College of Business at the University of Tennessee, Knoxville. “These plans are simple, with low fees, and offer a great deal of investment flexibility.”
A string of $2,000 Coverdell contributions can add up for families that start when the child is very young and enjoy decent investment returns. The $2,000 is an annual limit per child, regardless of the number of accounts. So if the parents put $2,000 into an account, the grandparents can put in nothing.
And, of course, having a Coverdell does not prevent you from having a 529 as well.
“You can use both by funding the Coverdell up to the limit and then contributing to a 529,” says Arielle O’Shea, investing expert with NerdWallet, the money management site. “This is a good option if you’re saving for college and a K-12 education expense like private school, since the Coverdell can be used for that.”
Among its appeals is the Coverdell’s flexibility. It can be set up though a bank, brokerage or mutual fund company and invested in just about anything you like — individual stocks, mutual funds, exchange-traded funds and real estate investment trusts. With a 529, in contrast, you must decide which state’s plan has the best combination of investment options and state tax breaks, and then you are limited to the mutual funds that state offers. With the options varying widely, it can be tricky to make apples-to-apples comparisons.
Here are some other considerations:
State tax treatment. As with 529s, there are no federal tax deductions on Coverdell contributions. But taxes are a consideration because some states offer residents state tax deductions on 529 contributions, while none do so for Coverdells. For people in high-tax states, this can tip the balance toward the 529.
“For example, the state of Indiana offers a 20 percent tax credit on up to $5,000 per year in contributions to an Indiana 529, which can be claimed against Indiana income tax,” says Ryan Kay, a financial advisor with AMI Investment Management in Kendallville, Indiana.
To get a state tax deduction on a 529, you must use your own state’s plan, and that’s not necessarily the most attractive 529 from an investment perspective. For a rundown on state tax treatment, use this calculator.
Fees. Unfortunately, there’s no simple answer on this. The wide investing options available to Coverdells may allow you to find fund companies or other providers with lower administrative expenses than you’d face with a 529 plan, but that’s not guaranteed, Canup says.
Fees could be an issue with a Coverdell that has a low account balance. So shop around.
Will things change? A Coverdell must be used by the time the beneficiary turns 30 or income tax and a 10 percent penalty will be charged on gains. There’s no such rule for 529s, so they are suited to a beneficiary who might, for example, go to graduate school later.
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Also, contributions can no longer be made to a Coverdell once the child turns 18, while money can be put into a 529 no matter how old the beneficiary. It’s also easier to shift 529 assets to a different beneficiary — a sibling, another relative, or anyone else.
“Know that unlike with a 529, this (Coverdell) money immediately becomes the property of the beneficiary,” O’Shea says. “You can change the beneficiary to another family member, but you can’t return the money to yourself as you can with a 529 plan.”
Taxable savings. While Coverdells and 529s are a great way to save for major college costs like tuition, room and board, some expenses are out of bounds, making it worthwhile to have some savings in ordinary taxable accounts as well, says Tracy Green, tax and planning specialist at Wells Fargo Advisors in St. Louis.
“Saving additional funds in a taxable account will enable you to pay for items such as transportation costs and personal expenses, which are not considered qualified education expenses,” Green says.
Rebalancing. A common option in 529 plans is the target-date fund, selected to match the student’s college start date. In the early years, most of the fund is invested in stocks to emphasize growth, but as the target date approaches funds are gradually shifted to short-term bonds for safety.
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Coverdell investors can use target-date funds as well, but may not if they are attracted by the wider array of options. In that case, it’s important for the Coverdell investor to take an active role in balancing risk and reward, shifting to more conservative holdings as need for funds gets closer.
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Making the Most of a Coverdell Savings Account originally appeared on usnews.com
