Fifteen Reasons to use Coverdell Education Savings Accounts 

Overview

You may be excused for saying, “Coverdell, what’s that? I never heard of them!” And you would be right. They used to be known as Education IRAs, and hardly anyone contributed to them because the annual contribution was only $500. How do you pay for $160,000 of college expenses with an account that, if you were lucky, accumulated only $18,000 by the time junior took his freshman vows?

In theory, Education IRAs were attractive. Although contributions were nondeductible, the income and gains were nontaxable if used to pay for qualified higher education expenses such as tuition, room and board, books, and supplies. If the fund was not used up by the time junior reached 30, the beneficiary could be changed to a younger child or other family member under age 30.

Education IRAs had a few drawbacks, however. If funds were not used for qualified college costs by age 30, the fund balance had to be distributed. The earnings then became taxable and subject to a 10% penalty. Further, most contributing families’ adjusted gross incomes were above the phase-out limits, so they were ineligible to make contributions. Also, the accounts could not be funded after the child reached age 18 and the account could only be used for college costs.

The Economic Growth and Tax Relief Reconciliation Act of 2001 made significant changes, making Coverdell accounts a viable strategy for investing for education expenses. Here are ten reasons why you should seriously consider them.
 

Reason 1: Increased Contribution Limits
For tax years beginning after 2001, the annual limit on contributions is increased to $2,000 per beneficiary. If $2,000 is contributed each year, at the beginning of the year, for 18 years with an 8% assumed rate of return, the account should grow to $80,892.

Reason 2: Increase Phase-Outs
The phase-out range for married individuals filing jointly has been increased to $190,000 to $220,000. For single and head of household individuals, the phase-out range is $95,000 to $110,000. More taxpayers will be eligible to contribute. Also, grandparents can contribute for grandchildren. 

Reason 3: Children Are Eligible To Contribute
Parents or grandparents who are phased-out due to income limits may make a gift to a child’s custodial account. The custodian, on behalf of the child, may contribute the $2,000 to a Coverdell account because generally children do not have adjusted gross incomes exceeding $95,000.

In other words, no family should be without a Coverdell account due solely to adjusted gross income phase-out limits.

Reason 4: Earnings Are Nontaxable
This benefit has not changed. Distributions for qualified expenses are tax-exempt.

Reason 5: Qualified Education Now Includes K through12 Education
Beginning in 2002 the definition of qualified education expenses now includes costs related to elementary and secondary education. These are tuition, fees, academic tutoring, books, supplies, equipment, room and board, uniforms, transportation, computers and technology, Internet access, and supplementary items or services. This can even include extended day programs. Kindergarten is even covered. It does matter whether the school is public, private, or religious.

Reason 6: Room and Board Definition Expanded
It used to be that qualified room and board expenses were limited to a college’s published financial aid guidelines. Beginning in 2002 there is no limit. Also, it used to be that if the student attended less than half time, room and board were not eligible expenses. That rule has been revoked, but just for qualified elementary and secondary room and board.

Reason 7: Corporations and Other Entities Can Contribute to Coverdell Accounts
The statute was amended as follows: the words “The maximum amount which a contributor” were struck from the statute and the words “In the case of a contributor who is an individual, the maximum amount the contributor…” were inserted. Corporations are considered “individuals” under the tax law. Tax exempt entities formed as corporations are also “individuals” under the tax law. There is no restriction on income at the corporate level. The individual adjusted gross income phase-out limits still apply. However, the contribution must be added to the W2 income of the employee.

Reason 8: Contribution Deadline Extended
The old law required a taxpayer to contribute on or before December 31. Beginning in 2002, a taxpayer may contribute up to April 15th of the following year for which the contribution is to be made. In fact, contributions made on or before April 15th are deemed to have been made on account of the previous year.

Reason 9: Excess Contribution Withdrawal Deadline Is Extended
If the contribution exceeds the $500 or $2,000 limits, a 6% excise tax applies. Under the old rules, an excess contribution had to be withdrawn by April 15th. Beginning in 2002, the deadline is extended until May 31.

Reason 10: No Excise Tax Penalty If Contribution to 529 Plan Made in Same Year
Beginning in 2002, contributions may be made to both a Coverdell account and a Section 529 Qualified Tuition Plan without incurring the old law 6% excess penalty tax. The only question is which type of account should be contributed to first.

Reason 11: No Age Distribution Limit For Special Needs Beneficiaries
Beginnng in 2002, the mandatory age 30 distribution requirement no longer applies for special needs individuals. Such as individual is defined as one who needs additional time to complete their education because of physical, mental, emotional or learning disabilities.

Reason 12: Coordination With Hope and Lifetime Learning Credits
Beginning in 2002, a taxpayer may claim either the Hope or Lifetime Learning Credit in the same year as a distribution is made from a Coverdell account. However, the credits cannot be taken on the same qualified expenses that were paid with the Coverdell account distribution.

Generally, taxpayers should consider claiming the Hope credit or the Lifetime Learning credit, if eligible. However, it is conceivable that the exclusion for distributions from the Coverdell account may have to be given up, which means the earnings will be taxable. The amount of the credit should exceed the additional tax; otherwise it makes no sense to give up the exclusion. Generally, the child will be in the 10% bracket, so keep that in mind.

Reason 13: Coordination With Section 529 Plans
If parents have established and funded a Section 529 plan as well as a Coverdell account, it is conceivable that payments to colleges may exceed the qualified education expenses. If that happens, the new law does away with the harsh result under the old law and no longer disallows all of the distributions from one or the other accounts. Now taxpayers merely have to allocate the qualified education expenses proporationately between the two accounts.

Reason 14: Asset Allocation and Investment Management Control
With the contribution limit raised to $2,000 per year, taxpayers can more easily spread any particular years distribution over a number of mutual funds. Many mutual funds have a lower $500 minimum for IRA accounts. This will facilitate better asset allocation. In addition, unlike a Section 529 plan, taxpayers have complete control over how contributions are invested in Coverdell accounts.

Reason 15: Coverdell Accounts Not Subject to the Sunset Rule
In the year 2011, all of the nice tax benefits of Section 529 plans may disappear. Not so with the Coverdell accounts. While the $2,000 limit may go back to $500, the exclusion of the earnings in the account from taxation was in the law before the Economic Growth and Tax Reconciliation Act.

Financial Aid Considerations

While the tax law allows significant tax benefits, the financial aid rules are not so kind to parents and students who may be eligible for financial aid. Generally, parents with less than $175,000 of adjusted gross income may be eligible for some financial aid. Parents who have higher than $200,000 of adjusted gross income may find Coverdell accounts to be suitable for investment. Generally, Coverdell accounts are assessed as a student asset at a rate of 35%. This means that financial aid will be reduced dollar-for-dollar 35 cents for each $1 of balance in the Coverdell account. In addition, the untaxed income will be assessed at 50%.

Example:  Johnny receives a distribution from his Coverdell account in his freshman year in the amount of $10,000 of which $3,000 represents accumulated dividends and unrealized gains from the stock market. Johnny will lose $5,000 in financial aid (35% of $10,000 plus 50% of $3,000). However, maybe Johnny won’t need significant amounts of financial aid because the $10,000 meets most of the first year tuition, making the Coverdell account a good deal for him.

As the example illustrates, while there is a loss of financial aid, perhaps a lesser amount is needed if a student plans on meeting a large percentage of his or her college costs.

One strategy parents may consider is to change beneficiaries from the one about to enter college to a younger sibling. This should be done before the first financial aid forms are filed. Later, the beneficiary can be changed back to the student in college, when that student has no need for financial aid.
 

Conclusion

In summary, from a tax viewpoint only, taxpayers should give priority to Coverdell accounts before considering Section 529 plans. The $2,000 annual contribution limit increase, the strategies for assuring that even the higher-income taxpayers can take advantage of these accounts, the easing of and flexibility of the new rules, and the investment management advantages make Coverdell accounts a great choice for tax-free college savings.

From a financial aid point of view, parents and students must consider the potential loss of financial aid, whether strategies can be implemented to avoid the loss, and if not, whether the tax benefits outweigh the potential loss of financial aid. For higher income parents, financial aid probably will not be a factor in the decision process.

This tax change letter is being published on our website and issued to clients with the understanding that we are attempting to provide information only. We are not providing tax or financial advice with respect to any given individual situation. Our services or the services of a competent tax or financial planning practitioner should be sought for the purpose of applying this information to specific situations.