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