Your Money: Coverdell Tuition Tax Break Still Controversial Even as End Nears

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. 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.
The late Senator Paul Coverdell, a Republican of Georgia, for whom the accounts were eventually named, locked horns with President Bill Clinton in 1997 over Mr. 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. Senator 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 Senator Edward M. Kennedy, Democrat of Massachusetts, who said in 1998 that he believed that an account like the one that Senator 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 Senator 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.”
Despite the Coverdell’s status as a sort of totem of school choice advocates, no one has figured out just 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. 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.