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Pluses and Minuses of Coverdell Accounts: Dealing with the Disadvantages (page 2)

By — John Wiley & Sons, Inc.
Updated on Oct 26, 2010

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.

Transferring The Money To Another Beneficiary

The assets in the Coverdell account belong to the designated beneficiary; so when you change that beneficiary to another child or other related person, you take these assets away from the first beneficiary, and he no longer has to count them on his financial aid application. You have, however, just made a new gift to the new beneficiary, and there may be gift tax consequences. In addition, you now need to pay careful attention to the financial aid needs of the new student. If you see financial aid applications in that child's future, you may want to consider paying down the remaining balance in the Coverdell account as quickly as possible by making qualified withdrawals covering primary and secondary educational expenses.

Do not transfer a Coverdell account to your original designated beneficiary's spouse if you want to maximize the amount of financial aid your original student will qualify for; spousal assets are included at the same rate as the student's own assets. Although married students are no longer treated as their parents' dependents for the purpose of financial aid calculations (so parental information is no longer included in the FAFSA), it doesn't matter whether it's your student or your student's spouse who actually owns the assets. Transferring an account to a spouse gives you more paperwork, but it doesn't change the final outcome on the student's financial aid application.

Closing The Account And Completely Distributing The Proceeds To Your Student

Finally, you may choose to close the Coverdell account and hand the distribution check over to your student. Your student will owe income tax on any accumulated income in the account and also a 10 percent penalty for the privilege of receiving a nonqualified distribution. Still, if the amount of income isn't great and your student has little or no other income to report on his tax return, the overall tax burden may be slight, and this option may be your best way out of this particular jam.

When choosing this option, though, you need to be aware of a couple points:

  • You're handing a chunk of change to a kid, who may not have the best money management skills. Actually, though, this is what you're hoping for in this scenario, because you really want that money to be spent.
  • If your student has wonderful money management skills and promptly stashes that cash away in a savings or investment account, he still has an asset that will be subject to a 20 percent inclusion rate on his FAFSA, which was the treatment you were trying to avoid in the first place. The only income that is counted in calculating his aid award, though, is the current income earned on that money, not the amount of any withdrawals that he takes. It's not much relief from the initial Coverdell/financial aid dilemma, but it's something.

Taking The Best Strategy If Your Student Receives Educational Assistance

I'm planning on my son receiving a four-year football scholarship (although he's not particularly athletic). If that fails, he will, of course, be a National Merit Scholar (did I mention he's brilliant?) and receive a four-year free ride to the college of his choice. So much for my fantasy life, and I have a rich one. In real life, I'm saving for his education because I figure I'll have to start paying tuition bills approximately ten years from now. Now, he may hit the jackpot and actually receive one of these scholarships, and if he does, I'll be prepared.

When your student receives any form of tax-free educational assistance, whether it be through veterans' benefits, employer tuition reimbursement plans, or outright scholarships and grants, any income from a Coverdell withdrawal originally distributed to cover those higher education expenses is taxable to that student, but no 10 percent penalty is assessed. Be careful, though " this exemption from the penalty exists only in the year or years in which your student actually receives the tax-free educational assistance and incurred higher education expenses. You can't save up your withdrawals until the account needs to terminate and then tell the IRS that there's still money in this account because your student received all this tax-free aid in prior years. To limit the amount of taxes your student will pay, go ahead and make withdrawals from the Coverdell account in years in which he receives the aid.

Keep in mind that tax brackets are incremental based on total income and that a student is usually in a lower bracket because he doesn't have much income. For example, if Nathan receives a full scholarship and his parents have established a Coverdell ESA for him that has $60,000 in it on his 18th birthday ($36,000 of contributions and $24,000 of accumulated income), they may want to consider making an equal distribution of $15,000 for four years, so that an equal amount of their original contribution ($9,000 x 4 = $36,000) is paid to him in each of his four years of college.

Because Nathan is receiving all this extra money, he's not going to have to get a summer job (probably) or do anything else to earn money for these years. If his parents are willing to make these withdrawals from his Coverdell account for nonqualified expenses, Nathan's tax situation will look like Table 10-1 (assuming that the money left in the account continues to earn income at the rate of 5 percent per year).

College Year

Total Annual Coverdell Withdrawal

Coverdell Contribution Amount

Coverdell Accumulated Earnings

Federal Income Tax on Accumulated Earnings @ 10%

Year 1

$15,000.00

$9,000.00

$6,000.00

$600.00

Year 2

$15,750.00

$9,000.00

$6,750.00

$675.00

Year 3

$16,537.50

$9,000.00

$7,537.50

$753.75

Year 4

$17,364.38

$9,000.00

$8,364.38

$836.44

Totals:

$64,651.88

$36,000.00

$28,651.88

$2,865.19

Table 10-1: Nathan's Federal Income Tax Situation when Nonqualifying Distributions Are Made in the Same Years that He Receives a Full-Tuition Scholarship

Now, suppose that Nathan's parents wait until his 30th birthday to make that distribution (at which point he is hopefully earning a reasonable sum of money), and assume that he hasn't gone to graduate school and completely depleted the account. In this situation, his parents risk increasing the percentage that he may pay in tax. Remember, the $60,000 that was sitting in his Coverdell account on his 18th birthday has now increased significantly (using the 5 percent per year assumption, the cash in the account has grown to over $107,750), and all that money will be coming out at one time, in a lump-sum distribution. Of the $107,750 total distribution, $71,750 represents accumulated earnings on which Nathan must pay income tax. If you assume that he's now paying in a 25 percent federal income tax bracket, his income tax on the lump sum distribution at his 30th birthday will be a princely $17,977.50. Added to that, he'll also pay an additional $7,175 penalty, for a total federal tax liability of $25,112.50, or more than $22,000 more than he would've paid in taxes had his parents made distributions to him in the same tax years that he was receiving his scholarship.

If your designated beneficiary also lives in a state with a so-called piggybacked income tax (where your state income tax is calculated by using a percentage of your federal income tax), he will pay a higher percentage of the total accumulated income in his Coverdell account not only in federal income tax but also in his state income tax. You should note, though, that state income tax numbers are piggybacked only on the actual federal income tax piece; if a penalty is applied, there should be no additional tax on the penalty portion. If you have another kid you're going to sending to college, you may also consider transferring the account to that beneficiary.

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