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529 E-ditorials

04-2: The Cover-up Education Savings Account
Joe Hurley
Tuesday, April 27th 2004

Don't get me wrong-I appreciate the Coverdell education savings account (ESA). Anything that helps families save for college is worth supporting. And now that ESAs can be tapped for primary- and secondary-school expenses, they are uniquely useful for families sending their children to private schools for grades K through 12. But I'm a little concerned about some reports I'm seeing that would push ESAs to the top of everyone's list of available college-savings options. Before investing your money in an ESA you need to know the facts, and this involves dispelling some myths about the ESA.

Myth #1 - ESAs remain tax-free after 2010

As most 529 plan investors know, the current federal tax exclusion on qualified 529 withdrawals expires at the end of 2010. And while I anticipate that Congress will ultimately act to extend the exclusion beyond the year 2010, I cannot provide any assurances. Many investors figure they do not have to worry about this problem with ESAs since their tax-free status for college purposes pre-dates the 2001 Tax Act and its 2010 "sunset" provision. What these folks may not realize is that the old law exempted ESA withdrawals only for taxpayers who chose not to claim the Hope or Lifetime Learning credit. Just about everyone was better off with the credit than with exemption of ESA earnings. Because of the sunset, this situation is scheduled to return in 2011, and those of us using ESAs for college will once again be forced to give up the ESA exemption in order to claim the more valuable credit. We can only hope that Congress does the right thing so that families using either 529 plans or ESAs don't have to pay tax on qualified withdrawals.

Myth #2 - ESAs are less expensive than 529 plans

Many 529 plans impose an asset-based program management fee, and some also impose a fixed-dollar, annual, account-maintenance fee. Although ESAs generally don’t charge a separate asset-based fee, most do charge annual account fees. And because the amount that can be invested in an ESA is limited to $2,000 per child per year, the impact of these fees on your investment return can be greater. A $20 annual account fee on a $2,000 ESA balance is equivalent to a 1% expense ratio. ESA costs could rise even further in the future as the IRS has made the recordkeeping burden extraordinarily difficult for the ESA administrators. Some mutual fund companies and brokerages (e.g. Fidelity) don’t even offer ESAs, while some others do offer ESAs but require that you maintain a substantial balance in their other investment products in order to assure a profit.

Many states offer special tax breaks to residents using their own 529 plans, and these breaks can more than offset the program-level fees and expenses. By investing in your own state’s 529 plan, you may be eligible for a tax deduction, a matching contribution, or some other valuable incentive. You don’t get these benefits with an ESA. Recently, the National Association of Securities Dealers (NASD) announced it was investigating certain broker-dealers for selling out-of-state 529 plans without appropriately advising clients about tax deductions attached to the in-state 529 plan. But I don’t see the NASD coming down on anyone for selling ESAs to clients who are eligible for 529 state tax breaks. Hardly seems fair.

Myth #3 - ESAs are less confusing than 529 plans

Admittedly, the plethora of state-crafted 529 plans along with their unique tax characteristics under federal and state law can make the choice and use of 529 plans a rather confusing process. But ESAs also have some issues, even though they all follow the same basic model.

Recordkeeping is one of the problems. The IRS may have figured they were doing everyone a favor when they recently switched the burden of maintaining ESA tax-basis records from the investor (like an IRA) to the plan provider (like a 529 plan). But the mid-stream change of direction is creating a recordkeeping quagmire. For certain rollovers and taxable distributions, you will need to know the tax basis of your ESA. Some investors, through no fault of the ESA administrator, will not have the correct information.

Then there is the issue of excess contributions. Let's assume Dad decides to use the ESA and plunks down $2,000 for his four-year old daughter. But Grandma also wants to help, so she puts $2,000 into a separate ESA for granddaughter. Together they have exceeded the annual contribution limit, and unless they somehow recognize the problem and retract the $2,000 excess contribution in time, the poor four-year old will be responsible for reporting and paying a 6% excise tax. That could lead to a sleepless naptime. (The same problem occurs with contributions made by taxpayers who discover too late that their adjusted gross incomes exceeded certain limits.)

Myth #4 - You can maintain control with an ESA

Many parents have set aside funds for college using Uniform Transfers to Minors Act (UTMA) accounts. The risk you take in establishing an UTMA is that your child gains direct control of the investment at a particular age established under state law, typically 18 or 21. With an ESA, that particular problem appears to go away. The federal tax law permits an ESA to remain under your control, provided you are designated the "responsible individual," until the ESA beneficiary reaches age 30, at which time the balance must be paid out to the beneficiary. You can also change the beneficiary of the ESA at any time to another family member under age 30.

But according to knowledgeable attorneys, the whole concept of ESA control is a fuzzy one. Questions of property ownership are decided under state laws, I'm told, not federal tax law. But one thing is clear: the ESA must be used for the benefit of the named beneficiary, and not for you, the donor or responsible individual. A 529 savings plan affords the ultimate level of control, placing no restrictions on your ability, outside of tax and penalty consequences, to use a withdrawal for whatever purpose you choose.

Myth #5 - ESAs offer more investment flexibility

Actually, this is not a myth. You can have a self-directed ESA whereas a self-directed 529 account is not allowed. The myth may be that greater investment flexibility is a good thing. That will depend on your ability (or your financial adviser's) to select and maintain an investment portfolio appropriate to your education-savings objective. The portfolios available in most 529 savings plans are specifically designed for that one objective.

Myth #6 - ESAs offer a good financial aid result

The good news is that the U.S. Department of Education recently came out with a notice stating that ESAs will now receive the same favorable treatment that 529 savings plans receive in determining eligibility for federal student aid. In years past, the ESA was disadvantageously considered the student's asset. The bad news is that the Education Department's former position makes more sense than their current position (see Myth # 4 above). ESA investors can only hope that the Education Department doesn't do another flip-flop.

Conclusion: The Coverdell ESA can be an excellent way to save for education costs, either alone or in combination with other investment alternatives. Just be sure you understand its risks and limitations.

» 05-4: The 529 marshals have arrived - 08/30/05
» Our 5.29th-year anniversary - 06/29/05
» 05-2: 529s and the new Bankruptcy Act - 04/28/05
» 05-1: Reform or Deform? - 02/27/05
» 04-6: Perspectives on the 529 debate - 12/28/04
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