Tax-free Coverdell savings accounts saved by Congress

Coverdell education savings accounts have never really drawn many headlines, even when unexpectedly saved from extinction as part of Washington's "fiscal cliff" deal.

Much like the 529 college savings programs that are familiar to many people, Coverdell ESAs are accounts where earnings grow tax-free, as long as withdrawals are used for qualified education expenses such as books, supplies or transportation.

Some key differences have always kept Coverdells out of the limelight. The biggest hurdle has been that contributions could total no more than $2,000 per year, as opposed to $24,000 or more per couple for 529s, depending on the particular plan.

There are no state-level tax advantages, as there are with 529s, and a family's modified adjusted gross income must be less than $110,000 (or $220,000 if filing a joint return), to establish an account and contribute annually. No such income limits exist for 529s.

While no figures have been compiled on just how much money taxpayers have invested in Coverdells since created in 2001, deposits in 2009 – the last year statistics were made available – amounted to just $718 million. The total invested in Coverdells is likely a tiny fraction of the $179 billion in the 529 system.

Because Coverdells are little used, many financial planners are not even aware they exist. In fact, observers expected the ESA would meet a quiet demise in 2013.

But Congress saved Coverdells from expiring once before as part of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010. Coverdells stand out, however, because they have key features 529 plans lack, which likely played a role in their preservation.

The new Coverdell rules in the American Taxpayer Relief Act preserve some unique advantages and offer some new tax-free savings opportunities for parents to defray the cost of education – from elementary through college years.

Contribution limits remain fixed at $2,000 per year, although Congress can act to change that ceiling at any time. There is now no age limit for special-needs students who seek to keep their accounts open. For other children, the remaining balance of any Coverdell account must be distributed once they reach age 30.

"It's another tool. Obviously it has limits and caps on it … but it's got its purpose," said Eleanor Blayney, consumer advocate for the Certified Financial Planner Board of Standards.

You can use both Coverdells and 529s in conjunction, but carefully. You have to justify any primary or secondary school expenses offset by your Coverdell to the Internal Revenue Service. What's more, you cannot justify the same college expenses to both accounts, Blayney said.

SPECIAL-NEEDS BENEFITS

The biggest advantage to Coverdells is that the funds can be used for expenses at the elementary and secondary levels, and for special services, none of which are covered by 529s.

Paul Coverdell, the late Republican senator from Georgia who championed the funds, saw them primarily as a way to offset private school tuition. Yet private school fees have sky-rocketed, making the income cap on the accounts generally too low for people who shell out $40,000 a year for kindergarten.

For parents of special-needs children, however, the accounts could be useful, said John Vento, a CPA who runs his own accounting firm in New York City and is the author of the upcoming book "Financial Independence (Getting to Point X): An Advisor's Guide to Comprehensive Wealth Management."

While $2,000 per year may not sound like a huge amount of money, it can make a difference for parents whose children may need special schooling that is not university-based and for a longer period of time.

Suppose your special-needs child has difficulty with handwriting. Coverdell funds can be used to buy computers, printers, peripherals and even Internet access to put that child on an even playing field with their peers, according to Vento.

"If your student needs a one-on-one aide with him and the school doesn't cover the expense, this service qualifies, as does special equipment necessary to accommodate him," he said.

In terms of the sheer math, Coverdells can add up over time. Investment options are open to any savings vehicle, such as exchange-traded funds, mutual funds or even individual stocks, as opposed to 529s, which are limited to what the plan sponsor offers and require a money manager.

If you save $2,000 a year for 18 years in a Coverdell, an 8 percent return will turn that into $74,900 – a yield of $38,900 that is completely tax free. Leave it alone until the child reaches 30 and it would be worth about $226,566, which could be helpful as a trust fund for later in life.

© Copyright 2013 Thomson Reuters. 

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