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6 myths about Coverdell accounts

Editor's note: The Pension Protection Act of 2006 signed into law by President Bush on Aug. 17, 2006 removes the 2010 expiration of the 529 tax exemption. Withdrawals from a 529 plan will continue to be completely tax-free when used for college. Read more.

Don't get me wrong, I appreciate the Coverdell Education Savings Account.

Anything that helps families save for college is worth supporting. And now that Coverdell accounts can be tapped for primary- and secondary-school expenses, they are uniquely useful for families sending their children to private schools for grades K through 12. But I'm a little concerned about some reports I'm seeing that would push Coverdell accounts to the top of everyone's list of available college-savings options.

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Before investing your money in an Coverdell account, you need to know the facts, and this involves dispelling some myths.

Myth No. 1 -- Coverdell accounts remain tax-free after 2010
As most 529 plan investors know, the current federal tax exclusion on qualified 529 withdrawals expires at the end of 2010. While I anticipate that Congress will ultimately act to extend the exclusion beyond the year 2010, there are no assurances.

Many investors figure they do not have to worry about this problem with Coverdell accounts since their tax-free status for college purposes predates the 2001 Tax Act and its 2010 sunset provision. What these folks may not realize is that the old law exempted Coverdell account withdrawals only for taxpayers who chose not to claim the Hope or Lifetime Learning credit. Just about everyone was better off with the credit than with exemption of Coverdell account earnings.

Because of the sunset, this situation is scheduled to return in 2011, and those of us using Coverdell accounts for college will once again be forced to give up the Coverdell account exemption to claim the more valuable credit. We can only hope that Congress does the right thing so that families using either 529 plans or Coverdell Education Savings Accounts, or ESAs, don't have to pay tax on qualified withdrawals.

Myth No. 2 -- Coverdell accounts are less expensive than 529 plans
Many 529 plans impose asset-based program management fees, and some also impose fixed-dollar, annual account-maintenance fees. Although Coverdell accounts generally don't charge a separate asset-based fee, most do charge annual account fees. Because the amount that can be invested in an Coverdell account is limited to $2,000 per child per year, the affect of these fees on your investment return can be greater. A $20 annual account fee on a $2,000 Coverdell account balance is equivalent to a 1-percent expense ratio.

Coverdell account costs could rise even further in the future as the Internal Revenue Service has made the record-keeping burden extraordinarily difficult for the Coverdell account administrators. Some mutual fund companies and brokerages such as Fidelity don't even offer Coverdell accounts, while some others do offer Coverdell accounts but require that you maintain a substantial balance in their other investment products to assure a profit.

Many states offer special tax breaks to residents using their own 529 plans, and these breaks can more than offset the program-level fees and expenses. By investing in your own state's 529 plan, you may be eligible for a tax deduction, a matching contribution or some other valuable incentive. You don't get these benefits with an Coverdell account.

Recently, the National Association of Securities Dealers, or NASD, announced it was investigating certain broker-dealers for selling out-of-state 529 plans without appropriately advising clients about tax deductions attached to the in-state 529 plan. But I don't see the NASD coming down on anyone for selling Coverdell accounts to clients who are eligible for 529 state tax breaks. Hardly seems fair.

Myth No. 3 -- Coverdell accounts are less confusing than 529 plans
Admittedly, the plethora of state-crafted 529 plans, along with their unique tax characteristics under federal and state law, can make the choice and use of 529 plans a rather confusing process. But Coverdell accounts also have some issues, even though they all follow the same basic model.

Record keeping is one of the problems. The IRS may have figured it was doing everyone a favor when it recently switched the burden of maintaining Coverdell account tax-basis records from the investor to the plan provider. But the midstream change of direction is creating a record-keeping quagmire. For certain rollovers and taxable distributions, you will need to know the tax basis of your Coverdell ESA. Some investors, through no fault of the Coverdell account administrator, will not have the correct information.


-- Updated: Oct. 18, 2006
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