Saving for Your Child's Education
- Mark Biller Sound Mind Investing
- 2013 25 Nov
Chances are you're familiar with the highlights of the ironically titled American Taxpayer Relief Act (ATRA), signed into law on January 2. The law returned payroll taxes to their previous higher levels and raised rates for high earners, among (many) other things.
While many of the new law's provisions (especially the negative ones) received wide publicity, buried in the details was a nugget for college savers. In recent years, "529" plans have become the default choice for tax-advantaged college savings. But the ATRA has breathed new life into their primary competitor, the Coverdell Education Savings Account (ESA). (Visit Savingforcollege.com to easily compare 529 Plans to Coverdell Education Savings Accounts.)
What the ATRA did was make most of the Coverdell provisions permanent. Since 2001, Coverdells have lived with the threat of "sunset" over their heads. Under previous law, the maximum contribution for Coverdell ESAs would have been lowered to only $500 a year. Such a change, of course, would have greatly reduced the usefulness of Coverdells as a college-savings vehicle.
What Is A Coverdell ESA?
Created in 1997 as "Education IRAs" and improved dramatically in 2001, Coverdell ESAs (named for the late Sen. Paul Coverdell of Georgia) are a compelling savings vehicle for parents whose income falls below the law's income limits. Parents with an adjusted gross income below $190,000 (filing jointly) may contribute up to $2,000 per child, per year, to a Coverdell ESA. (The contribution ceiling is gradually lowered for taxpayers with modified adjusted gross incomes between $190,000 and $220,000; those with incomes over $220,000 may not contribute to a Coverdell ESA. Limits are $95,000 and $110,000 respectively for single filers.) Coverdell contributions aren't deductible, but all earnings grow tax-deferred and can be withdrawn tax-free if used to pay the student's college expenses.
Furthermore, anyone (grandparents, other relatives, friends) can contribute to your child's Coverdell account as long as they meet the income-eligibility rules; however, the total contribution from all sources can't be more than $2,000 a year. (It's possible to set up multiple Coverdell ESAs for the same child, but there's not much point because, again, the total contribution—for all accounts taken together—is capped at $2,000.) A scant $2,000 per year may not seem like much when college costs run into the tens of thousands per year, but a steady stream of $2,000 contributions can add up—if you start early. Assuming an annual earnings rate of 8%, $2,000 per year would accumulate to more than $70,000 over 18 years.
Why Coverdell ESAs Are A Big Deal
Coverdells have two significant advantages over 529 plans. First, they allow you the flexibility to choose the specific investments you desire. This is important for those who want to direct their own investment program, as many SMI members prefer to do. Most fund companies or brokerages can set up a Coverdell ESA for you, allowing access to their full range of investment products.
This means you not only can pursue a passive index-fund strategy such as Just-the-Basics but a more aggressive active strategy such as Fund Upgrading if you choose. (Most 529 plans offer index-fund options, which you can use to roughly duplicate our Just-the-Basics strategy, but their limited menu of funds beyond that makes Upgrading impossible.) While Upgrading's recent performance has been similar to JtB, its longer-term performance has been superior. Ten years ago, if you had $10,000 in a Coverdell ESA and had Upgraded with it, you'd have $30,691 today, even if no new money was added. If the same amount had been invested using Just-the-Basics, you would have $27,187. That's a noticeable difference.
Another, perhaps less obvious, benefit of using a Coverdell account is that having total control of your investment options potentially affords you a longer period to pursue a higher-returning strategy. For example, with a 529 plan, you can change investments only once per year, and even then you're usually limited to relatively broad-based index funds. That limitation makes it risky to maintain a large stock allocation as the child approaches college age. But with a Coverdell ESA, you can do more fine-tuning. For example, you might start out with an Upgrading-dominated allocation initially, but instead of having to reduce your stock allocation as the child ages, you might feel comfortable transitioning the account gradually toward our Dynamic Asset Allocation strategy, which is lower risk than Upgrading but still maintains high growth potential. This could lengthen the amount of time the portfolio has for higher potential earnings.
The second major advantage of Coverdells is that the favored tax treatment of earnings extends to cover elementary and secondary school expenses. This makes Coverdell accounts particularly attractive for parents who want to send their children to a private elementary or high school. The list of qualified expenses is lengthy, and includes obvious items such as tuition, room/board, and books (as well as some non-obvious items, including school uniforms, transportation, computers, and Internet access for the family during the years the beneficiary is in school).
A word about Coverdell ESAs and financial aid: Prior to 2007, Coverdell accounts that were set up in a child's name were considered to be assets of the student when it came to calculating financial aid eligibility. Under current law, assets in a Coverdell account are considered to be assets of the parent(s) for the purposes of calculating financial aid (as long as the student is still a dependent). This is true even if the account is in the child's name. In most cases, this benefits a student who is seeking financial aid because need-based financial aid formulas weigh a student's assets much more heavily than parental assets.
For investors who are primarily pursuing indexing strategies, excellent 529 plan options are available. But for investors who want to pursue more active strategies, the flexibility provided by Coverdell ESAs is great. Thankfully, there's no "either-or" decision between Coverdells and 529 plans. If you want to fund a Coverdell ESA up to $2,000 each year and then continue saving via a 529 plan, you can.
Mark Biller is the Executive Editor at Sound Mind Investing. Since its founding by Austin Pryor 23 years ago, SMI has been providing clear, trustworthy, effective investment guidance to the Christian community. Some 10,000 subscribers look to its flagship publication, the Sound Mind Investing monthly newsletter, for biblical guidance on a range of financial issues and specific, market-beating investment advice.
Publication date: November 25, 2013