With tuition costs soaring, saving for education is more important than ever, and Coverdell ESAs have been one of the most flexible ways to take advantage of tax breaks with your college savings. But with the fiscal cliff coming, Coverdell ESAs could easily end up becoming even less useful than they are now.
A retirement account that's not for retirement?
Originally, Coverdell ESAs were known as Education IRAs. That name caused a lot of confusion, however, since the accounts weren't actually for retirement like most IRAs. Therefore, the name was later changed to honor Sen. Paul Coverdell, the lawmaker who most strongly advocated for the creation of these education savings accounts.
ESA stands for "education savings account," and that better describes what the purpose of the Coverdell ESA is. Anyone, including parents and grandparents, can open a Coverdell account for a child, contributing up to $2,000 annually. Although you have to use after-tax money for contributions, Coverdells act in a manner similar to Roth IRAs in that as long as you use the money for educational purposes, any income or capital gains earned within the account is free of federal income tax.
In many ways, Coverdell ESAs are similar to another college savings strategy, the 529 plan. Both share many of the same tax benefits, for example. But 529 plans limit you to set menus of investment options, generally requiring you to choose from a narrow array of mutual funds and potentially incurring substantial management fees. Coverdell ESAs, on the other hand, allow you to use just about any stock, bond, mutual fund, exchange-traded fund, or other investment to help save for college. In addition, Coverdells do something that 529 plans don't: You can use money in a Coverdell for educational expenses not just in college but in high school and elementary education as well.
Why Coverdells never took off
The main problem with Coverdell ESAs, though, is the limited amount you can contribute. The current $2,000 annual limit will only let you make a small dent in the likely cost of your child's college education, even if you start at birth and contribute the maximum every year.
Even worse, Coverdells are in line to be among the victims of the coming fiscal cliff. Unless Congress acts to extend the provisions that set the $2,000 limit, Coverdell accountholders will only be able to contribute $500 into their accounts in 2013 and beyond. Moreover, the ability to use Coverdells for elementary school or high school expenses is slated to go away as well.
By contrast, most 529 plans have much more generous limits. Account maximums of $200,000 or more are common, and you can generally put in large amounts in one fell swoop rather than having to portion them out over a number of years.
It's likely because of the low limits on contributions that some financial providers have backed away from Coverdell ESAs as realistic options for college savings. Nearly two years ago, financial services company Vanguard stopped allowing new applications for Coverdell ESAs, although it didn't force existing customers to close their accounts. If contributions are limited even further, then you can expect more financial services companies to join Vanguard in deciding that they simply aren't viable to offer from a business perspective.
What to do now
Despite these concerns, you shouldn't hesitate to open a Coverdell ESA if you prefer its features to other college savings strategies. Even if the accounts were phased out entirely, tax law provisions allow you to roll over Coverdell balances to a 529 plan. That won't necessarily be the perfect solution, but at the very least, you won't have to worry about having that money disappear entirely.
Meanwhile, there's always the chance that Congress will support education savings by raising annual contribution limits. If lawmakers do extend higher limits, you may find Coverdell ESAs to be your best, most efficient bet for college savings.
