Saving for School the Coverdell Way/ October 20th, 2003
Whenever parents ask financial planner Mike Arnow how to provide for their children's education, his favorite answer is the Coverdell Education Savings Account. The Coverdell account--set up through any number of financial institutions such as credit unions or mutual fund companies--is a tax-privileged savings vehicle that replaces and improves upon the old Education IRA (individual retirement account). It's a creature of Congress and a ward of the Internal Revenue Service (IRS), so the Coverdell account has restrictions and technicalities and caveats. (For details, see Publication 970 at the IRS Web site) But for Arnow, a certified public accountant and certified financial planner in Glendale, Wis., it's the single best way to save for school, particularly for middle-income families. "It's wonderful," Arnow says. Costs for higher education are going through the roof. Tuition for pubic colleges has risen more than triple the increase in median family income in the 1980s and 1990s, according to the College Board, a national nonprofit membership association in New York that informs students about college opportunities. At the same time, though, families can ill-afford not to send their children to college when the median income for someone with a bachelor's degree is 80% more than someone with just a high-school diploma. The chief feature of Coverdell accounts is that they shelter investment growth from the tax collector. That means that savings set aside in such accounts--plus the earnings they make--are fully available for qualified school bills. Besides protecting earnings from taxes, Coverdell accounts offer investment flexibility, transferability, and tax-free withdrawals to cover education costs such as books, tuition, and room and board. And they're not just for college kids.
Talk to someone at your credit union about starting a Coverdell account."The Coverdell could be used at any school, public or private, and even for grammar school and high school," Arnow says. They're also available for students with special needs, regardless of their age.
Start earlyNamed for the late Sen. Paul Coverdell (R., Ga.) who championed the savings plans, the Coverdell accounts encourage families to start early to raise money for children's schooling. Contributions are limited to $2,000 a year per beneficiary, which amounts to about $166 a month. That's a far cry from the $12,841 the College Board estimates it cost to attend a public college in 2002-2003. But bit by bit, those savings can accumulate into a tidy sum. "In terms of the $2,000 a year, that is sufficient for most families to pay for college if you start early enough," Arnow says. At what Arnow regards as a historically conservative 8.5% annual rate of return, setting aside $166 a month would yield more than $81,000 from birth to when a child turns 18. The key here is starting early. If, in the same example, contributions begin later, at age 6, the total would reach only $40,000 by the time the child is 18.
Another planThe renaming of the accounts and recent enhancements (including greater flexibility and quadrupled contribution limits) have been overshadowed by the so-called 529 plans, which also offer tax-free investment earnings for college.
For greatest impact, start saving early.The 529 plans, named for a section of the tax code, vary by state and have more advantages for upper-income savers, including contribution limits of up to $200,000 in many states. Also, the 529 tax benefits aren't restricted by a contributor's income level, as they are for the Coverdell accounts. For Coverdell donors, benefits phase out beginning at adjusted gross incomes of $95,000 for single taxpayers and $190,000 for married couples. For families under those income limits, though, Coverdell accounts offer a wider range of where education savings may be invested and how they may be spent. The 529 plans can offer some state tax breaks, but the funds may be used only to cover certain college expenses, not for elementary or secondary school. If you can afford it, you may contribute to both a 529 plan and a Coverdell.
Other considerationsSaving $2,000 a year per child through a Coverdell account can be challenging for some parents, but grandparents and others also can pitch in, as long as the total annual contribution doesn't exceed $2,000 per child. Excessive contributions are subject to a 6% tax. One source of funding to consider is the federal child tax credit of $1,000 per child. Each year, parents should try squirreling away that amount for education, says Kay Shirley, a certified financial planner in Atlanta. "This would be a good idea," says Shirley, president of Financial Development Corp. "Because of the ever-increasing costs associated with higher education, parents should use whatever resources are available to help fund a child's education."
Coverdell accounts let education savings grow tax-free.Coverdell contributions must stop when the child reaches 18, and the account must be spent on schooling by the time the beneficiary reaches 30, unless the student has special needs. Otherwise, the earnings could be subject to income taxes as well as a 10% penalty. However, another beauty of the Coverdell account is that unused portions may be transferred to a relative--a sibling, niece, nephew, even cousin--to keep the education savings in the family and avoid tax penalties. One consideration is whether guardians prefer to keep control of the account even after the child reaches adulthood. The other option is to let the child take charge as an adult. "You should review the document establishing the account at your financial institution carefully before you invest, to determine which option applies," advises Christine Fahlund, senior financial planner at T. Rowe Price Investment Services, in Baltimore. "If it is not to your liking, continue your search for an institution that offers the arrangement you are seeking." Coverdell savings could adversely affect your child's qualifications for financial aid when it's time to apply for college. But remember, the whole point of financial planning is to arrange matters so that you're in control of a situation and not relying on someone else's determination of what you can afford. "Financial aid is always a consideration," Arnow says, "but it is not really designed for the middle class and above." As to where to invest Coverdell savings, Arnow suggests low-fee, balanced mutual funds with a wide diversity of holdings. "Normally what I say to people is you want an all-weather fund, something that has stocks, bonds, and cash," Arnow says, "something where [a professional fund manager] is going to make the decision for you on how to move it around."