Consumers have had an excellent opportunity to help pay for their children’s educational expenses by contributing up to $2,000 a year to Coverdell Education Savings Accounts. Contributions, though not tax deductible, grow tax deferred and withdrawals to pay for qualified educational expenses from kindergarten through college have been tax free. Covered expenses have included: tuition, room and board, computers, extended day programs, academic tutoring, equipment, uniforms, and transportation. However, starting next year, withdrawals to pay for educational expenses incurred from kindergarten through 12th grade will no longer be tax free unless Congress extends the benefit (which is in doubt). Consumers who have relied on Coverdell Accounts to pay for pre-College educational expenses need to be aware of this potential glitch before making this year’s contribution. Another possible rule change would reduce the annual contribution limit back to $500 starting next year. Likewise, prospects in Congress for preserving the $2,000 annual limit remain uncertain.
Individuals with modified adjusted gross income below $95,000 are eligible to make the maximum annual contribution of $2000, while the limit for joint filers is $190,000. Eligibility for the maximum annual contribution gradually shrinks to zero for individuals with modified adjusted incomes between $95,000 and $110,000, and for joint filers with modified adjusted gross incomes between $190,000 and $220,000. To avoid these income restrictions, a child can use money received as a gift to make his own contribution to a Coverdell Account. The impact on financial aid is identical to the effect of contributions made in a parent’s name. Never the less, regardless of who makes the contribution, the annual maximum is $2,000 per child.
There are a number of other restrictions with Coverdell Accounts. First, beneficiaries of the accounts must be under age 18 when contributions are made, and the money can only be used for the beneficiary. Second, no refunds are available to the person who initiates the account. Third, if the beneficiary reaches age 30 without using the money, it will be distributed to the beneficiary and become taxable. However, the person who set up the account can change the beneficiary at any time to another family member under age 30.
Contributors to Coverdell Accounts can select their own investments. Unlike 529 College Savings Plans which limit investor choices to a limited menu of investments, the only investment prohibited for Coverdell accounts is life insurance. Never the less, financial institutions that offer Coverdell accounts can set their own investment restrictions. For example, Charles Schwab Investments does not allow risky and often illiquid investments such as coins and antiques. Schwab also disallows other exotic investments like futures contracts and other financial derivatives from Coverdell accounts.
Again, unlike 529 College Savings Plans that limit changing investments to once a year, Coverdell contributors can switch among investments as often as they like. Though switching investments often can be costly, it’s a nice option to have. Speaking of costs, be careful of firms’ set up charges to set up and annual fees to maintain an account. With Coverdell accounts’ relatively low contribution limits, even a modest $25 annual fee can cut deeply into returns.