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Coverdell fade-out! What should you do?
Amy Buttell is a freelance writer based in Pennsylvania
The sun will soon set on parts of the Coverdell Education Savings Account but that doesn't mean the entire program will fade to black.
The changes, however, are significant and anyone with money invested in a Coverdell should take a long hard look at the pared-down program to determine if any reallocation of funds is in order.
The Coverdell, long a stepchild to the more popular Section 529 plan, received a time-limited makeover as part of the 2001 tax cut law. But the extension of the program that came with that law will expire at the end of 2010 unless reversed by Congress. Joe Hurley, CPA and founder of Savingforcollege.com, isn't optimistic that Congress will extend the benefits.
It's not the end of the line for Coverdells — they will continue to exist regardless of whether Congress acts to extend the tax breaks and other advantages. However, if not extended, the amount of money you can contribute to the plan will be cut drastically, certain tax advantages will expire and funds will again be restricted to college expenses only. Currently, you can spend Coverdell funds on qualified kindergarten through 12th grade expenses.
While Coverdells don't get much attention, they do offer some advantages and still may be worthy of consideration when deciding where to place your college savings, says Christine Moriarty, a Certified Financial Planner with MoneyPeace in Bristol, Vt. "Coverdells offer flexibility and benefits that 529 plans don't have, so it's another option for parents when saving and spending," she says.
Parents and grandparents now should look at three basic alternatives says Hurley:
- Leave Coverdell funds in place.
- Spend the money on qualified college or kindergarten through 12th-grade expenses.
- Roll the funds over into a 529 plan.
What the 2010 sunset means
When Congress revamped the Coverdell program in 2001 it limited many of the provisions, including tax rate cuts and estate tax repeal in an effort to avoid adding to the federal budget deficit over the long term. Initially, Section 529 plans were also scheduled to sunset, but Congress voted to repeal the sunset on 529 plans since then.
Here are the provisions that will be lost if, Congress does not vote to repeal the sunset — which the president must also sign:
- Maximum annual contributions will be reduced from $2,000 to $500.
- Only college-related expenses - and not kindergarten through 12th grade expenses - will be considered qualified spending. Tax-free withdrawals of interest, dividends and capital gains to fund K-12 expenses no longer will be permitted. Any amounts accumulated in the accounts at the higher contribution limit can remain in the accounts, but you will have to pay tax on the investment gains in any amounts you withdraw for K - 12 expenses after Dec. 31, 2010.
- Claiming Hope and Lifetime Learning Credits the same year as a tax-free Coverdell distribution is taken will no longer be permitted. This limits your flexibility, as there is no such limitation on a 529 plan, Hurley says.
Both credits are available to married taxpayers with income below $96,000 and phase out as income exceeds $116,000 in 2009. Under the Hope Credit, you can claim the first $1,200 of qualified educational expenses and 50 percent of the next $1,200. The Lifetime Learning Credit takes the form of a $2,000 credit for qualified expenses.
Rolling Coverdells into 529 plans
To avoid dealing with the hassles of post-sunset Coverdells, you can roll your Coverdell accounts into a 529 plan, says Hurley. Because 529 plans and Coverdells are different types of accounts — Coverdells are custodial accounts that are owned by the account beneficiary and 529 plans are owned by the parents or grandparents who establish them — you have to follow a couple of steps when making a rollover.
"You have to take the money out of the Coverdell and put an equal or larger amount of money into a 529 plan during that same year," says Hurley. "You then inform the 529 plan when you are making the contribution that the money is coming out of a Coverdell Education Savings Account. You have to do it yourself because there is currently no mechanism set up for a trustee-to-trustee rollover."
When you handle the rollover this way, there are no adverse tax consequences because it's a tax-free transaction, as long as the 529 plan is set up for the benefit of the same person as on the Coverdell. Technically, you should establish a custodial 529 to transfer the Coverdell money because Coverdells, unlike 529 plans, are set up for the benefit of one person and some Coverdell accounts do not permit a change in beneficiary while the current beneficiary is still a minor, Hurley says.
However, state law is murky on this subject and for all intents and purposes, states are unlikely to insist that Coverdell funds rolled over into a 529 plan be placed into a custodial 529 plan, Hurley says. And the issue is moot if you spend the funds for the benefit of the child for whom the Coverdell was originally established.
Spending Coverdell funds
Another way to avoid the potential problems of post-sunset Coverdells is to spend any funds you have in such accounts before the end of 2010. If your child is college age or nearing college age, you have plenty of options as there is no shortage of expenses associated with attending college, says Moriarty.
These can include a new laptop and deposits for tuition or housing, books, tuition, room and board, among many other qualified expenses, she says. Not only colleges qualify: You can use the funds for vocational and other postsecondary training. If your child isn't close to college age, qualified kindergarten through 12th-grade expenses are eligible, including private school tuition and fees and the cost of a computer that is used for educational purposes.
As long as you spend the funds before Jan. 1, 2011, any interest, dividends and capital gains you accrue from your Coverdell accounts are tax-free when you withdraw them, which won't be the case for K -12 expenses after that date, should you retain your Coverdell account past that point.
Maintaining your Coverdell account
Your last option is to leave your Coverdell account as is and spend the money towards college expenses once they occur. If you decide to take this approach, despite the disadvantages, or just plain forget to spend the funds or move them, all is not lost, says Moriarty.
Coverdells offer flexibility in terms of investment choices that 529 plans lack, she says. You can set up a Coverdell with virtually any bank, mutual fund or brokerage firm and have complete control over your investment options. You could put your Coverdell funds in a savings account, certificate of deposit, mutual fund, stock or bond. You can also change investment options as often as you like, Moriarty says.
You have no such flexibility with 529 plans, where you have to choose among the investment options offered within a state plan. In addition, you can only change investment options once a year, except in 2009, when Congress has allowed a special exception so that you can change investment options twice.
"I encourage parents to use a variety of savings vehicles when saving for college because it gives them more options when it comes time to spend the money," says Moriarty. "If you have some money in a Coverdell, you have investment flexibility, while you can put more money into a 529 plan. And if you have a Uniform Gift to Minors, you can spend out of that in ways that you can't with a Coverdell or 529 plan. It just gives you more choices and options."
Posted August 14, 2009