Pluses and Minuses of Coverdell Accounts: Dealing with the Disadvantages

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You need to be aware of stuff that may make you think twice about investing in Coverdell ESAs. Coverdell accounts don't make sense for a lot of parents because of these negatives. Conversely, you may decide that a Coverdell account makes sense, but only in a very limited way, if you keep the amounts invested small, or if you use them only for the short term.

Whether your overall savings come up short (so you'll need to apply for financial aid), your student actually wins some outright scholarship aid (so you have more money in your child's Coverdell account than you need), or your child decides against any education beyond high school, you need to stay on top of how having a Coverdell account for that child will play into these scenarios, and figure out ways to minimize any negative consequences.

Minimizing A Coverdell Account's Impact On Financial Aid Awards

Hopefully, you won't even need to read this part, because you've been successful in your savings ventures and you have all the money you and your student need to see him through college or any other postsecondary educational endeavor. If, however, your savings are a little short and you're not earning quite enough to make up the gap every year, you need to pay attention. Coverdell accounts can become negative in this type of scenario. You need to carefully monitor your particular situation to avoid the minefield.

There's just no good way to say this: A Coverdell ESA may pose a dilemma if its designated student needs to apply for financial aid. Basically, if you choose to save only in a Coverdell account and those savings are insufficient for your student's needs, your student will be penalized for having such a conscientious parent. The value of assets in a Coverdell account are considered to belong to the student, and federal financial aid rules will include 20 percent of the value of the student's assets as part of the expected family contribution (or EFC, which is the amount that the Department of Education calculates you should be able to pay for one child's educational costs in any given year) available to pay college expenses.

When your student applies for any financial aid, the existence of a Coverdell ESA in his name will only hurt him. Coverdells are unlike Section 529 plans, which are considered to be an asset of the account owner (and if the owner is a grandparent, relative, or family friend who's not a part of your immediate family, it's not reported on the Free Application for Federal Student Aid, or FAFSA, form at all). Coverdell accounts are counted entirely as the student's assets and included at a far higher rate than so-called parent assets. A maximum of 5.64 percent of the value of a Section 529 plan and just about any other nonretirement parent asset other than home equity and life insurance are included in the formula used to arrive at the EFC because you're considered to be the plan owner, even if your student is the designated beneficiary. With a Coverdell, however, because the student is considered the owner of the plan, a whopping 20 percent of the total value of the Coverdell account is included in that formula.

And it just gets worse. In addition to counting 20 percent of the value of the account as available to pay current expenses, the total amount of any distributions your student received in the prior year is also included on his current year financial aid application, even if none of the distribution was taxable. Because the folks at the Department of Education assume that the parents are responsible for supporting their child and that all the child's income is then available for education expenses, 50 percent of that child's income (adjusted for a small income protection allowance), whether taxable or not, is counted as available to pay educational expenses.

If you have a small Coverdell account for your student, the asset and income inclusions probably won't impact his financial aid award too adversely. If you're successful in making contributions and even more successful in your investments, however, the existence of that Coverdell plan may effectively prevent your student from receiving certain forms of financial aid. In addition, he may well be saddled with paying back full-cost, unsubsidized Stafford Loans at the end of his college career. Of course, if your student isn't likely to ever qualify for need-based financial aid, you don't need to worry about this consideration.

There are, of course, ways around this dilemma. If you choose to save inside one of these accounts for your student and your student still needs additional funds, it doesn't mean that your saving was in vain, your student is doomed to a ten-year payback of high-cost loans, and you're a failure. This problem has some possible solutions, but you need to be on top of the fact that you have a problem well before you ever complete that first financial aid application.

Spending Down Your Student's Coverdell Account Early

First, you may choose to use up your student's Coverdell account before he reaches college and starts applying for financial aid. Remember, you may use Coverdell distributions to pay for all qualifying educational expenses for both primary and secondary school, as well as for postsecondary school, and the rules concerning what qualifies are far more lax for K-12 expenses than for college ones.

Even if your child doesn't attend private school, many expenses that qualify during his primary and secondary years don't qualify for postsecondary education . If you can manage to make the final distribution from your Coverdell plan before your child applies for financial aid (ideally, a year or two before filing the FAFSA), perhaps by buying that new computer that you know he'll need for school or by paying for some extra tutoring, the fact that a Coverdell account once existed for this student won't make one whit of difference in your child's aid award.

Rolling Over Your Student's Coverdell Account Into A Section 529 Plan

If you can't completely exhaust your student's Coverdell account before he's likely to start applying for financial aid, you may consider rolling the account over into a 529 plan for your student. The rollover is tax-free if you complete it within 60 days of the initial withdrawal from the Coverdell account.

In a rollover to a Section 529 plan, you need to keep in mind the following:

• If you choose to distribute the funds from the Coverdell account directly to your student and then you contribute that exact amount into a Section 529 plan, you retain control over the new Section 529 account. The Section 529 plan is counted as your asset (included at only 5.64 percent in the financial aid formula), and you have the ability to change the designated beneficiary.

If you choose the rollover option, you've just made a new gift to your student (the original Coverdell contributions, which you've just distributed, were gifts to that child when you made them; the new Section 529 contribution is a completely new gift). You may have some gift tax consequences here.