If you read our summary of the proposed regulations for the federal scholarship tax credit (also known as Section 25F), you may have found yourself scratching your head at the mention of Coverdell accounts. You aren’t alone. You could spend your entire career in education without hearing of these seldom-used accounts. But they have suddenly become important thanks to the new federal tax credit, which borrows Coverdell’s provisions and, based on the latest from Treasury, may end up rewriting them.
So, what are Coverdell accounts? Why haven’t you heard of them? And why should we care about them now?
What to Know
Coverdell Education Savings Accounts are small, tax-advantaged accounts for a child’s education expenses, similar to a Roth IRA. Contributions aren’t deductible, but earnings grow and come out tax-free when used for qualified expenses. Contributions are capped at $2,000 per child per year, and contributors face income limits. Congress created the accounts in 1997 as “Education IRAs” for college costs, with a $500 annual cap. In 2001, Congress raised the cap and expanded them to K-12, over objections from Sen. Ted Kennedy and others who saw a back door to subsidizing private school. The accounts were renamed for Sen. Paul Coverdell of Georgia, who championed the K-12 expansion and died in 2000.
Coverdell accounts couldn’t compete with Section 529 plans. Both came about in the late ’90s, but changes made to 529 plans in 2001 that made college withdrawals tax-free, with no meaningful contribution cap, no income limits on contributors and state tax deductions in most states, made them the popular choice with families. Coverdell assets in mutual funds totaled about $7 billion at the end of 2019, against hundreds of billions of dollars in 529s. That 2019 figure is the last one anyone published, and the IRS keeps no public accounting.
Why it Matters
On its face, it may make sense that the authors of the One Big Beautiful Bill Act, which includes Section 25F, would borrow their definition of qualified expenses from a statute that lets families save for education. Borrowing is standard practice in tax code drafting, but borrowed definitions don’t always drop in cleanly. Section 25F also borrows its disqualified person rules from the private foundation statute and its income limit from the low-income housing credit, and Treasury had to adjust both. But those statutes came with decades of guidance to work from, which isn’t the case for Coverdell accounts. Given the lack of interest in them, the IRS has issued limited guidance particularly for the even-more-rarely-used K-12 provisions.
Digging into the Coverdell language also highlights critical differences between the two programs. A Coverdell family was spending at most $2,000 a year of its own after-tax money, nobody verified an expense before the money went out, and if the IRS ever disagreed, the penalty was tax plus 10% on the earnings portion of the withdrawal, typically a small amount. For that family, what counts as “academic tutoring,” or what it means for tutoring to be “incurred in connection with the enrollment or attendance” of a student at a school, probably wasn’t that important. Under 25F, a program Treasury projects will reach nearly $26 billion a year, those questions fall to SGOs, families and schools, all of whom bear the consequences of getting it wrong. An SGO must verify each expense before paying it, only qualified expenses count toward its 90% spending requirement, and it certifies compliance every year under an annual independent audit with its SGO status at stake.
The differences in language across the Coverdell provisions matter more as well. Section 530 ties tutoring, special needs services, books and supplies to the student’s “enrollment or attendance” at a school, but computer technology and internet access need only be “used by the beneficiary and the beneficiary’s family during any of the years the beneficiary is in school.” For a Coverdell family, that gap was never worth much attention. For 25F, it will have to be determined whether it sets a different standard, and if so, how connected tutoring needs to be to what is happening in school while a home computer and internet plan need no connection at all. Those answers will have to wait for the guidance Treasury has promised.
Given the lack of interest in Coverdell accounts to date, that guidance will effectively hijack the Coverdell rules to meet the needs of the federal scholarship tax credit. Those new rules would apply to Coverdell accounts too, but who will notice?
