The Coverdell Education Savings Account lets people put away up to $2,000 each year in an investment account. While the contributions are not tax-deductible, you don't pay any taxes on the earnings you take out as long as you use them for tuition or other qualified expenses, including those for elementary or secondary education.
In this, the hour of the annual tuition bill, the season of the fiscal cliff, let us pause to gaze in wonder at a true curiosity: the tax break for people who send their children to private or religious schools for kindergarten through 12th grade.
If you’re not familiar with it, you’re not alone. Plenty of otherwise savvy tax professionals and financial planners don’t know much about it, either. It’s called the Coverdell Education Savings Account, and there is nothing else like it.
The Coverdell lets people put away up to $2,000 each year in an investment account.
While the contributions are not tax-deductible, you don’t pay any taxes on the earnings you take out as long as you use them for tuition or other qualified expenses, including those for elementary or secondary education.
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Even with that annual contribution limit, the tax savings can add up to thousands of dollars for people who are persistent savers.
Now, however, the question is whether this quirk will last.
As with a lot of things in the tax code, the Coverdell tax break for elementary and secondary tuition costs is scheduled to expire on Dec. 31, absent some legislative action in Washington.
Whether you want to root for its continued existence may depend on your political outlook.
The years of debate over whether this tax break should have come into existence in the first place featured some of the most colorful political rhetoric in recent history.
Coverdell vs. Clinton
The late Sen. Paul Coverdell, R-Ga., for whom the accounts were eventually named, locked horns with President Clinton in 1997 over Clinton’s threat to veto the senator’s effort to create accounts that would give tax breaks to parents who steer their children away from public schools.
Coverdell said the threat, which the president later made good on, was “almost a Pearl Harbor for education reform.”
Why was the president so opposed? Cue the late Sen. Edward Kennedy, D-Mass., who said in 1998 that he believed that an account like the one that Coverdell had proposed “hangs the sign for all to see on the front door of public schools of America, ‘Abandon hope all ye who enter here. Get out while you can.’ “
Newt Gingrich, then the speaker of the House, had seen the accounts much differently one year earlier, speaking of “parents and children who want the right not to be destroyed by bad schools.”
He and Coverdell finally got their way in 2001, when President George W. Bush signed a bill allowing holders of what became known as Coverdell accounts to use the earnings for kindergarten through 12th grade education, albeit with a $2,000 annual contribution cap.
“In terms of a financial benefit, you’re talking de minimis,” Joe McTighe, executive director of the Council for American Private Education, said this week.
“But in terms of its historical importance, it carried a lot of weight. As far as I know, it’s the first federal tax relief specifically helping parents with kids in religious or independent elementary and secondary schools,” McTighe said.
Despite the Coverdell’s status as a sort of totem of school-choice advocates, no one has managed to figure out how many people are using the accounts to pay for a primary or secondary school education today.
The Internal Revenue Service does not know, and neither do the big brokerage firms like Charles Schwab and Merrill Lynch that offer Coverdells.
What we do know is that overall use of Coverdells, which people can also use to save for college, has been falling quickly, declining from 985,000 tax returns mentioning contributions to Coverdells in 2005 to 644,000 in 2009, according to a brief released this week by the Joint Committee on Taxation.
More attractive options
The committee said the decline was probably because of the low Coverdell contribution limits compared with other tax-advantaged ways of saving for college, like 529 accounts.
That said, it’s possible that many more people would be in on the Coverdells if they knew about the tax breaks for parents with children in private or religious schools.
Here’s how those tax savings break down, according to Jason Derbyshire, business-development manager for the company that makes TradeLog accounting software for active traders and investors.
If parents saved $2,000 for each of 16 years in a normal brokerage account, earned returns of 6 percent for each year (a realistic return for someone in a mix of stock and bond index mutual funds who rebalances annually) and then pulled the entire balance out in the summer of the 17th year, they’d end up with $54,425.76. Those 16 annual $2,000 contributions mean their cost basis for capital-gains tax calculation purposes would be $32,000, leaving them with a $22,425.76 capital gain.
In a normal taxable brokerage account, the long-term capital-gains tax would be 15 percent of that gain for most parents, or $3,363.86. In a Coverdell, however, the account holder pays no taxes as long as the money is used for a qualified education expense.
And every little bit helps when facing down an annual bill for, say, $51,025 for boarding students at the Lawrenceville School in Lawrenceville, N.J., or more than $25,000 for many private day schools around the country.
The tax savings would be higher if the account earned more than 6 percent, if capital-gains tax rates increased or if the account owners let it grow longer than 17 years by changing the beneficiary of the Coverdell from the oldest child to the youngest one.
And lest you think that Coverdells are merely a plaything for the private-school parent, Christopher E. Condeluci, a lawyer at Venable in Washington and a former tax and benefits counsel for the Senate Finance Committee, points out that parents of children in public schools can use the accounts in several ways, too.
The IRS Coverdell rule book notes one nearly universal possibility: using account distributions for computers and Internet access.
Then, there are the more complicated tax maneuvers some people have tried in order to use a Coverdell.
The rules prohibit contributions from people who have modified adjusted gross income of more than $110,000 for singles and $220,000 for couples filing a joint return.
But the regulations did not specifically prohibit wealthier parents from giving gifts to their minor children to open their own accounts, and the IRS does repeatedly point to beneficiaries’ ability to make contributions on their own behalf. People wealthy enough to consider this kind of fancy footwork probably ought to pay an experienced tax accountant to review it.
If you’re new to this Coverdell private and religious school angle, you may well wonder why you’d want to bother opening an account because of the uncertainty around the tax rules come Dec. 31, 2012.
One potential reason is that Rep. Ann Marie Buerkle, R-N.Y., has introduced legislation with Rep. Mike Kelly, R-Pa., proposing to raise the annual contribution limit to $10,000. The odds are probably long here given the federal deficit troubles. “I don’t see how they can afford something like that these days,” said Joe Hurley, founder of the savingforcollege.com website.
At the opposite extreme, legislators may allow the tax-free savings for kindergarten through 12th grade education to expire at the end of the year and let the annual contribution cap for higher-education savings fall to $500 to pay for higher-priority tax breaks.
Then again, Coverdells probably aren’t costing much now in the broad scheme of things. In 2010, the Joint Committee on Taxation predicted the tax breaks this year would deprive the U.S. Treasury of just $17 million.
Robert Enlow, president of the Foundation for Educational Choice, doesn’t see the Coverdell break going away.
He points to the many pieces of legislation that states have passed in support of vouchers or other means to allow parents more control of where their children go to school as evidence the political winds are at the back of those who want to keep using Coverdells for public and secondary-school tuition.
“People are tired of ZIP-code assignment in public schools, and that’s a bipartisan desire,” he said. “The current system is seen as having such an unfair impact on low-income families, and things like Coverdells, vouchers and tax credits really are being seen as ways to shake the system up a little more.”
If he’s wrong, however, it’s no great loss for Coverdell account holders. Even if they lose the ability to use their tax-free earnings for elementary- or secondary-school costs, there’s always college, and they could keep contributing toward that goal if they wished.
With tuition continuing to rise to levels that boggle the mind, parents across a range of income levels will need all the tax breaks they can get.