For College Savings, Could Coverdells Rival 529s?

Could Coverdell education savings accounts play a vital role in clients' education planning?

“Its time may have come,” Savingforcollege.com founder Joe Hurley recently wrote on his website.

The tax benefits related to Coverdell education savings accounts, or ESAs, were made permanent by the American Taxpayer Relief Act of 2012 and now could be a prime competitor for 529 college savings plans.

Among their advantages, ESA investors may be able to choose from a broad range of investment options, while 529 owners generally are limited to the plan’s menu. ESA investment opportunities can include low-cost vehicles. Investment earnings are tax-free inside an ESA and withdrawals also are untaxed if the money is used for qualified education costs. Moreover, for 529 distributions to be tax-free, the money must be spent on higher education; untaxed ESA withdrawals can begin as early as kindergarten. You can tap an ESA for private school tuition and academic tutoring, for example.

What’s more, the competition for ESA assets might not be as fierce as they are for 529 plans. While many brokerage firms offer ESAs, many large fund companies don’t. Hurley points out that Vanguard and T. Rowe Price have stopped taking new ESA applications, and Fidelity has never offered them.

On the downside, ESAs can be funded only while the student beneficiary is under age 18. Contributions are limited to $2,000 per year, per student. ESA contributions are irrevocable so the money in the account must be spent for the student’s education. If you want to change the beneficiary of an ESA, the replacement must be a family member. Nonqualified distributions, which include those made for expenses other than education and those at the mandatory termination when the beneficiary reaches age 30, are subject to tax and a 10% penalty on the investment buildup.

In addition, anyone with modified adjusted gross income (MAGI) over $110,000 ($220,000 for a married couple filing a joint tax return) can’t contribute anything to an ESA. “If your income is too high,” Hurley, who is a CPA, suggests, “first gift the ESA money to your child and have the contribution come from the child.”

At $2,000 per student per year, an ESA generally won’t pay for all or even most education costs. Nevertheless, advisors who suggest them may impress clients of young children and demonstrate planning ideas that go beyond the conventional wisdom.