6 myths about Coverdell accounts
-- Page 2
Then there is the
issue of excess contributions. Let's assume Dad decides to use the Coverdell account
and plunks down $2,000 for his 4-year old daughter. But Grandma also wants to
help, so she puts $2,000 into a separate Coverdell ESA for granddaughter. Together
they have exceeded the annual contribution limit. Unless they somehow recognize
the problem and retract the $2,000 excess contribution in time, the poor preschooler
will be responsible for reporting and paying a 6 percent excise tax. That could
lead to a restless naptime. The same problem occurs with contributions made by
taxpayers who discover too late that their adjusted gross incomes exceeded certain
No. 4 -- You can maintain control with an Coverdell account
have set aside funds for college using Uniform Transfers to Minors Act (UTMA)
accounts. The risk you take in establishing an UTMA is that your child gains direct
control of the investment at a particular age established under state law, typically
18 or 21. With an Coverdell account, that particular problem appears to go away.
The federal tax law permits an Coverdell account to remain under your control,
provided you are designated the "responsible individual," until the
Coverdell account beneficiary reaches age 30, at which time the balance must be
paid out to the beneficiary. You can also change the beneficiary of the Coverdell
account at any time to another family member under age 30.
lawyers familiar with this area say the whole concept of Coverdell account control
is a fuzzy one. Questions of property ownership are decided under state laws,
I'm told, not federal tax law. But one thing is clear: The Coverdell account must
be used for the benefit of the named beneficiary, and not for you, the donor or
responsible individual. A 529 savings plan affords the ultimate level of control,
placing no restrictions on your ability, outside of tax and penalty consequences,
to use a withdrawal for whatever purpose you choose.
No. 5 -- Coverdell accounts offer more investment flexibility
this is not a myth. You can have a self-directed Coverdell ESA, whereas a self-directed
529 account is not allowed. The myth may be that greater investment flexibility
is a good thing. That will depend on your (or your financial adviser's) ability
to select and maintain an investment portfolio appropriate to your education-savings
objective. The portfolios available in most 529 savings plans are designed for
that one objective.
Myth No. 6 -- Coverdell
accounts offer a good financial aid result
The good news is that the
U.S. Department of Education recently came out with a notice stating that Coverdell
accounts will now receive the same favorable treatment that 529 savings plans
receive in determining eligibility for federal student aid. In years past, the
Coverdell account was disadvantageously considered the student's asset. The bad
news is that the Education Department's former position makes more sense than
their current position (see Myth No. 4 above). Coverdell account investors can
only hope that the Education Department doesn't do another flip-flop.
The Coverdell Coverdell account can be an excellent way to save for education
costs, either alone or in combination with other investment alternatives. Just
be sure you understand its risks and limitations.