Should we terminate the Coverdell Education Savings Account?

There are many options available for families looking to save money for school. You can use a 529 prepaid or savings plan, UGMA or UTMA accounts, savings bonds, trusts, taxable accounts like bank or brokerage accounts, or the Coverdell ESA (education savings account) . But the Coverdell never really took off, and with the passage of the Tax Cuts & Jobs Act of 2017 and the SECURE Act of 2019, we don’t really need it anymore.

Are Coverdells good?

Coverdells remain an option to consider for investors who are a little more financially savvy than average and who meet income criteria, particularly if they are in a condition that not offer benefits for contributing to a 529 account. Coverdells shares many of the favorite tax and financial aid treatments of 529 plans, but with a wider selection of investments.

In order to contribute to a Coverdell, the family must have an Adjusted Gross Income (MAGI) equal to or less than $ 95,000 if they are filing alone or $ 190,000 if they are married and filing jointly. The ability to contribute to a Coverdell gradually disappears up to the limit of $ 110,000 and $ 220,000, respectively, when families above these amounts are no longer eligible. Most families are eligible to contribute; the median income in the United States was around $ 62,000 in 2018, according to the US Census Bureau.

Coverdell account owners will find that there is a major advantage over other tax-deferred college investment accounts – they can invest in any security on the provider’s platform. For example, if you open a Coverdell through TD Ameritrade or E * Trade, you will have access to all of the stocks, bonds, ETFs and other securities they offer. If you want tax-deferred college savings and the broadest possible investment selection, the Coverdell can’t be beat.

The Case to Kill the Coverdell

Despite greater investment flexibility, the Coverdell never really gained widespread utility. The root cause: The Coverdell contribution limit has never been indexed to a measure of inflation. Annual contributions have been capped at $ 2,000 per beneficiary for almost two decades. The College Board estimates that students spend about $ 1,240 on books and supplies each year. Also, it can be difficult to coordinate: what if a grandparent wants to open an account for the same beneficiary as the parent? Their combined contributions cannot exceed $ 2,000 or are subject to a 6% excise tax on excessive contributions.

Also, keep in mind that the specialized nature and complex regulatory requirements of offering a Coverdell account don’t make them really attractive from a financial provider’s perspective. Businesses need a sufficient scale that it is useful to create account opening documents, deposit and withdrawal forms, disclosures, train their representatives, code and implement accounts, implement implement surveillance, etc. It is expensive to administer these accounts knowing that the maximum that will be deposited each year is $ 2,000, which is why you have never seen a Coverdell ESA ad. Every business offering a Coverdell is likely losing money on that account in the hope that the account owner will use their other services to cover the costs.

The relative disadvantages of Coverdells increased with the passage of the Tax Cuts & Jobs Act of 2017 and the SECURE Act of 2019. The legislation had little direct impact on Coverdells, but instead augmented the venerable 529 plan. So While the Coverdell once had the benefit of allowing qualified withdrawals for K-12 spending, now 529 plans can be used for up to $ 10,000 in tuition at K-12 schools. Additionally, withdrawals from a 529 plan for apprenticeship programs and student loan repayment (up to $ 10,000) are now considered eligible, making Coverdell accounts decidedly less versatile as 529 shots.

Coverdells are also not eligible for state tax benefits such as deductions and credits in states that offer them to 529 account holders, currently over 30. Many states also offer some form of additional incentive such as exclusion from consideration of financial aid in public schools. , Matching Grant programs and Newborn Grants, all exclusive to 529.

Additionally, Coverdell accounts have an expiration date. 529 account holders can potentially hold these accounts indefinitely, continue to contribute, and use any excess for future generations to attend college. Once the recipient of a Coverdell turns 18, any additional contributions are subject to an annual excise tax of 6%. In addition, the accounts must be liquidated and distributed to the beneficiary at the age of 30 if the assets have not already been used.

Few families use the accounts. ISS Market Intelligence estimated that $ 26 billion in assets were held in Coverdell’s ESAs in 2018, representing just over 2% of Americans’ college savings. This is compared to over $ 311 billion in 529 savings and prepaid plans.

Finally: How well are Coverdell account holders managing their assets? A 529 plan is sponsored and overseen by a state or board of directors which acts as a trustee, arranges investment options, and in many cases, hires independent consultants to assess and ensure their plan features the best. possible investments. The vast majority of the 529 account holders use age-based or target risk options, which rebalance automatically and regularly. For better or worse, only the Coverdell account owner exercises oversight and due diligence on the investments they select, unless they hire a financial professional.

With a lack of marketing, education, income and membership limits, no state benefits, less versatility than the 529 account, and no third-party oversight, there are fewer incentives than ever to use. the Coverdell.

The Coverdell has almost been killed before

The Coverdell was championed by the late Senator Paul Coverdell and implemented in the Taxpayer Relief Act of 1997 as “Education IRAs”, before being renamed in 2002 as the Coverdell Education Savings Account. Keep in mind that this is a year after Congress authorized 529 plans with the Small Business Job Protection Act of 1996. However, 529 plans did not really gain visibility until the Economic Growth and Tax Reconciliation Relief Act from 2001, when withdrawals became tax exempt. for eligible expenses (rather than tax-deferred). With this, and the ability of third-party vendors to make a modest profit, there was an incentive to market and distribute the 529 plan that the Coverdell never saw. Many revisions over the next two decades would see significant improvements to 529 plans while Coverdells received minor updates and little attention.

Fast forward to 2017, where before the Tax Cuts and Jobs Act, the House Ways and Means Committee introduced provisions allowing Coverdell participants to maintain their accounts or consolidate them into 529 plans. However, the original language would have prohibited contributions to their Coverdell in subsequent years. This iteration was never incorporated into the Tax Cuts & Jobs Act, so Coverdells continues to move forward. However, the option of deploying Coverdells in 529 plans remained, showing that lawmakers are playing with the idea of ​​shutting down Coverdell.

Should the Coverdell be removed?

For existing investors who don’t want to be limited to the menu offered by a 529 plan and who qualify under the income limits, the Coverdell offers versatility in its investment options. But people with an investment mind are few in number, which is reflected in their estimated asset levels compared to other college savings and investment vehicles. The disadvantages of Coverdell no longer outweigh its modest advantages over other options for most investors.

With few people using the accounts and their existence blurring the college savings landscape, there is little reason to keep them. It is one more investment option for the IRS and the SEC to monitor, regulate, update and manage at taxpayer expense given the modest investor benefit. With the SECURE Act of 2019 making the 529 plan even more versatile, the time may have come to do away with the venerable Coverdell education savings account altogether.

Additional information

If you would like to learn more about Coverdells and how it works, you can find full details in IRS publication 970, section 7. There you will find definitions of qualifying expenses, institutions, and all the minutiae associated with accounts.

If you are interested in opening a Coverdell ESA, you can find a list of providers here.

This information does not constitute tax advice and is provided for informational purposes only. Please consult your tax advisor, financial advisor, local tax authority and / or plan provider or sponsor for more information.