There are a lot of options available for families looking to put money away for school. You could 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 has never really taken off and, with the passage of the Tax Cuts & Jobs Act of 2017 and SECURE Act of 2019, we don’t really need it anymore.
The Coverdell Education Savings Account cannot fill college seats without significant help from … [+]
Are Coverdells Any Good?
Coverdells are still an option to consider for investors that are a little more financially savvy than average and who meet the income criteria, particularly if they’re in a state that does not offer benefits for contributing to a 529 account. Coverdells share many of the preferred tax and financial aid treatments of 529 plans, but with greater investment selection.
In order to contribute to a Coverdell the family must have a modified adjusted gross income (MAGI) at or below $95,000 if filing singly or $190,000 if married filing jointly. The ability to contribute to a Coverdell phases out up to the limit of $110,000 and $220,000, respectively, where families above those amounts are no longer eligible. Most families qualify to contribute; the median income in the United States was about $62,000 in 2018, according to the U.S. Census Bureau.
Coverdell account owners will find there is one major benefit relative to 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 would have access to all the stocks, bonds, ETFs, and other securities they offer. If you want tax-deferred savings for college and the broadest possible investment selection, the Coverdell cannot be beat.
The Case To Kill The Coverdell
Despite greater investment flexibility, the Coverdell has never really gained widespread utility. The main cause: The Coverdell contribution limit was never indexed to any inflation metric. Annual contributions have been capped at $2,000 per beneficiary for nearly two decades. The College Board estimates students spend about $1,240 on books and supplies alone each year. Further, it can be challenging 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 they are subject to a 6% excise tax on excessive contributions.
With their low contribution limits, Coverdells are unlikely to make much of a dent in most student’s … [+]
Keep in mind too that the specialized nature and complex regulatory requirements of offering a Coverdell account doesn’t exactly make them attractive to offer from a financial provider perspective. Firms need sufficient scale to make it worthwhile to create account opening documentation, deposit and withdrawal forms, disclosures, train their representatives, code and implement the accounts, implement oversight, and on and on. It is expensive to administer these accounts knowing the most that will ever get deposited each year is $2,000, which is why you have never seen a Coverdell ESA advertisement. Every firm offering a Coverdell is likely losing money on that account in the hopes that the account owner uses their other services to cover the cost.
The relative downsides of Coverdells grew with passage of the Tax Cuts & Jobs Act of 2017 and the SECURE Act of 2019. The legislation had little direct impact on Coverdells, but rather augmented the venerable 529 plan. Where once the Coverdell had the advantage of allowing qualified withdrawals for K-12 expenses, now 529 plans can be used for up to $10,000 of tuition at K-12 schools. Further, withdrawals from a 529 plan for apprenticeship programs and student loan repayment (up to $10,000) are now considered qualified, making Coverdell accounts decidedly less versatile than 529 plans.
Coverdells also do not qualify for state tax benefits such as deductions and credits in the states that offer them to 529 account owners, currently numbering over 30. Many states also offer some form of additional incentive such as exclusion from consideration in financial aid at state schools, matching grant programs, and newborn grants, all exclusive to the 529.
Further, Coverdell accounts have an expiration date. 529 account owners can potentially hold those accounts indefinitely, continuing to contribute and using any surplus for future generations to attend college. After the beneficiary of a Coverdell turns 18 any further contributions are subject to a 6% annual excise tax. Plus, the accounts must be liquidated and distributed to the beneficiary once they turn 30 if the assets have not already been used.
Not many families are using the accounts. ISS Market Intelligence estimated $26 billion in assets were held in Coverdell ESAs as of 2018, accounting for a little over 2% of college savings among Americans. This is compared with over $311B in 529 savings and prepaid plans.
Nearly a quarter century since their introduction, Coverdells have never really gained widespread … [+]
Lastly: How well are Coverdell account holders managing their assets? A 529 plan is sponsored and overseen by a state or board who acts as a fiduciary, curating investment options and in many cases hiring independent consultants to assess and ensure their plan has the best possible investments available. The vast majority of 529 account owners use age-based or target-risk options, which rebalance automatically and regularly. For better or worse, the Coverdell account owner alone is performing oversight and due diligence on the investments they select unless they hire a financial professional.
With lack of marketing, education, income and contribution 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 Was Almost 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 one 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 of 2001, when withdrawals became tax-free for qualified expenses (rather than tax-deferred). With this, and the ability of third-party providers 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 extensive improvements to 529 plans while Coverdells received minor updates and little attention.
Fast-forward to 2017, where prior to the Tax Cuts & Jobs Act the House Ways and Means Committee introduced provisions allowing Coverdell participants to maintain their accounts or roll them in 529 plans. However, the original language would have prohibited contributions to their Coverdell in subsequent years. That iteration never made it into the Tax Cuts & Jobs Act, and so Coverdells continue to plod along. However, the ability to roll Coverdells into 529 plans remained, showing that legislators are toying with the idea of shuttering the Coverdell.
Should The Coverdell Be Eliminated?
For existing investors that do not want to be restricted to the menu offered by a 529 plan, and who qualify under the income limits, the Coverdell offers versatility in its investment options. But those individuals with the investment savvy are few, which shows in their estimated asset levels relative to other college savings and investment vehicles. The drawbacks of the Coverdell no longer outweigh its modest benefits relative to other options for most investors.
With few people using the accounts and their existence muddying the college savings landscape, there is little reason to keep them around. It’s one more investment option for the IRS and SEC to oversee, regulate, update, and manage at taxpayer expense given the modest investor upside. With the SECURE Act of 2019 making the 529 plan even more versatile, now may be a good time to discontinue the venerable Coverdell Education Savings Account entirely.
Additional Information
If you want to do some more digging into Coverdells and how they work, you can find all the details in IRS Publication 970, Section 7. There you can find definitions of qualified expenses, institutions, and all the minutiae associated with the 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 taxing authority, and/or plan provider or sponsor for more information.