Mar 10, 2021

The Case for Coverdell Education Savings Plans

Much is written about 529 plans, the standard tax-advantaged savings plan for a college education. (They are legally known as “qualified tuition plans,” authorized by Section 529 of the Internal Revenue Code.) Their benefits are wonderful - nearly unlimited savings and tax advantages, flexibility and sometimes a state tax credit or deduction.

For those few with significant resources, it is the no-brainer choice for putting away tens of thousands of dollars into a tax-free college fund for your children's college education.

But for most parents, a Coverdell Education Savings Plan (ESA) not only works just fine, they generally provide more investment options and lower fees. Further, withdrawals can be used for qualified elementary and secondary education expenses as well as for college.

Coverdell accounts limit contributions to $2,000 a year per child for those with an adjusted gross income under $220,000 (joint). But the vast majority of households are under this income limit. Further, for the average family with about two children, saving $4,000 a year is realistically about their college savings limit.

Both 529 plans and Coverdell ESAs offer great benefits. They allow for tax free growth as long as the proceeds are used to pay for qualified education expenses. The plans remain your assets, not your child's, which means you are not committed to giving them this money.

And because the assets are yours, they have significantly less negative impact on financial aid. (Note that if funds are not used for education or other purposes the IRS approves of, the gains are eventually taxed with an additional penalty.)

529 plans are set up separately in each of the fifty states and their rules vary by state. In general, contribution limits are much higher than Coverdell’s, there are no income limits for contributors and have no age limits for beneficiaries.

Further, some states offer a state income tax deduction or credit for contributions to 529 plans but not for Coverdell plans. Again, these are great benefits for high income families trying to save a lot of money for their children's college expenses.

But at the more modest income and savings levels most of us live, a Coverdell ESA is often the better plan. Further, even if you have a Coverdell ESA, you can also have a 529 plan. Here's how the Coverdell works.

Coverdells are widely available at large brokerage firms, such as TD Ameritrade, E-Trade and Charles Schwab, with low minimum balances and no annual fees. You can generally invest in most of what they sell, which is just about everything, usually with no trading costs. Further, they offer broad very low-cost indexed funds, which are considered the best investment for most investors.

For example, you can open a Coverdell at Charles Schwab with no minimum and no maintenance fees. They charge no commissions on online equity trades with no minimums on trades. They also offer standard indexed funds with fees as little as .03%. Note that this is three hundredths of one percent, which is essentially zero. For a typical education savings account of $25,000, the fee comes to less than ten dollars a year.

Here’s some quick math on such a Coverdell. Over the past 100 years, the S&P 500 index (an index of the 500 largest U.S. stocks covering approximately 80% of the U.S. market capitalization), has returned a little over 8% a year after accounting for inflation.

Let’s assume you invest the maximum $2,000 a year into an S&P 500 indexed fund with near zero expenses. Assuming an average rate of return, your child will have about $80,000 in their Coverdell account in today’s dollars, which would cover most of the expense of a 4-year in-state college degree.

Let’s compare this with a 529 plan. My quick check found that most firms admit to fees up to 1% a year, an amount that could cut your total return significantly. 529 plans generally invest in a limited number of mutual funds, which tend to have higher turnover in their accounts, raising the total fees for these funds.

In life, simple and easy is not always preferable to complex and difficult. But in the financial world today, simple and easy usually means cheaper and better. In the past several decades, largely because of software and the internet, complex financial dealings have become simple products readily available at ultra-low costs to almost anyone.

But financial firms have struggled moving to a world where much of their former work has become largely valueless. Therefore, many work hard to obfuscate how little is needed to get a great return on your investments, instead encouraging products and services you probably have little need for.

This appears to be the case with 529 plans. Most aren’t set up, as are Coverdell’s, to have you simply invest your money in a near-zero fee indexed exchange traded fund, where the firm receives little income and you receive almost all of the gains from the underlying investments.

I did some research on 529 plans offered by Edward Jones. They quickly told me that “investing is personal” and immediately wanted my name so they can put me in touch with one of their financial advisors “to help.”

Unfortunately, these financial advisors are probably not going to help show you that your best option may be an ultra-low-cost Coverdell account where their firm will get less than $10 a year in fees. No surprise, Edward Jones doesn't even offer them. Instead, they quickly try to convince you of all the benefits of their 529 plans.

I tried to find fee information for their 529 plans. I never found any figures but I did find this buried away in their documentation: “529 plans will have fees and expenses, which will lower the rate of return. 529 plans generally carry sales charges (and) built-in operating expenses that affect the fund’s return (including) distribution and marketing fees (12b-1 fees), management fees, networking fees, annual account maintenance fees and transaction fees. Edward Jones receives a portion of the sales charge on 529 plans, and your financial advisor receives a percentage of that sales charge. Further, Edward Jones receives ongoing service fee payments, provided by the 12b-1 fees, and your financial advisor receives a portion of those ongoing service fees.”

Sales charges, distribution and management fees, networking fees, annual maintenance fees, transaction fees, sales charges, service fees. Only a fool would believe their fees are anything close to the $10 a year a typical education savings plan can cost you in a Coverdell ESA with a low-cost brokerage firm.

In comparison to these often complicated plans, a Coverdell ESA is just a simple brokerage account with IRS tax advantages. Otherwise, they function as another brokerage account, often including ultra-low costs.

Coverdell accounts have one other great feature, and that is they generally allow you to purchase almost any investment sold by the brokerage firm. In comparison, 529 plans are often limited to a subset of their mutual funds, often with higher fees than low-cost indexed exchange traded funds broadly offered by brokerage firms.

If you have a 401(k), this may sound familiar. 401(k)s are great retirement savings plans, but a little investigation shows that the same money in an IRA with a low-cost brokerage firm offers far more investment options at a lower cost. That is why whenever you are given the option, it is normally wise to transfer a 401(k) into an IRA, but that’s another topic.

529 plans are a great plan for many, especially for high-income taxpayers, primarily because they have few upper limits for income and contributions, and can offer a state deduction or credit. But when these are not considerations, which is true for most of us, a Coverdell account is a better option. They generally are easy to set up, have lower costs and more investment options, and provide more ways that the money can be used for a child’s education.

As always, 529 plans are different for each state and Coverdell accounts are different with every brokerage firm, so you are encouraged to do your own research before investing in anything.

Jan 11, 2021

Investing for 2021

We just closed out one of the most dramatic years for investing in a long time. The NASDAQ rose nearly 50% in the past year and has nearly doubled in the past two years; the S&P 500 rose 18% in 2020 and is up nearly 50% (including dividends) in the past two years. Tesla is up about nine times in a year, 25% so far in 2021, and bitcoin nearly five times in a year.

Ignoring for a moment the short and steep COVID drop this past March, 2020 continued what may be the biggest and best bull market ever. It started just weeks after Obama took office twelve years ago. From that low, the S&P 500 has risen over five times.

So where do we go now with this "everything rally" continuing to climb? I'll start with my general investing thoughts for any time.
 
The message that may be hardest to hear in a moment like this is that market timing is a bad plan. But it is still the plan that the human mind naturally goes to. A short history in human evolution shows that for most of our existence, the longest time frame normally needed for survival is one revolution of the earth around the sun. That's a good time period for growing crops, hunting animals and selecting a place to live.

And that's about the timeline that people unfortunately use for many aspects of modern life, specifically investing. Whereas following the crowd has been solid fishing advice for eons, it's not very good advice for investing. Buying now into any of 2020s hot investments is most likely a bad timing plan, but it is the prevailing thought.

Unlike fishing, market timing, normally turns into "buying high, selling low." The people that make money in hot markets are those who were in early and stayed in. The people who lose get in late and then leave after they've lost.

Market timing mostly devolves into chasing returns, sometime referred to as "managing for mediocrity." The adage "a fool and his money are soon parted" aptly applies.

So what can we do in a hot market like today? One of the first things is to evaluate how you are currently invested. What is the allocation you earlier established for your investments, if any? The simplest thing to do is to reallocate back to where you said you wanted to be. That's an easy way to "sell high."

Whether or not you have an allocation established, this is a good time to revisit that allocation. Consider how, regardless of recent returns, you should have your money allocated for the next several years. A good approach, regardless of age, is to keep any money you need in the next five years in cash or fixed income investments, and invest the rest in equities. Equities can safely be kept in a simple, low-cost S&P 500 index fund. They also can be partially allocated into foreign markets.

Another good review of your investments is to figure out the expenses incurred with each investment. Modern technology has made equities available to even the smallest investor at almost no cost. If you have funds charging over .5%, they should go.

Many "no-cost" investments have insidious hidden fees. Funds with high turnover are indirectly charging you for all their trading costs. 401K's are notorious for high fees. If you are able to transfer out, fees are normally considerably lower in an IRA with a low-cost brokerage firm than in a 401K. (But be careful with any transfer to ensure you are not taxed or penalized.)

If you are using a professional investment manager, make sure you understand where they make their money. They are professionals not just at managing your money, but also managing it to ensure they are paid well for their services.

As part of a review of your investments and allocation, also be sure you include all your investments, including you (and your spouse's) 401Ks, IRAs, savings accounts, savings bonds and brokerage accounts.

Do you understand everything you own? If not, either research the investment so you do understand what it is, or sell it and buy something you do understand. The two easiest investments for a well-managed portfolio of any size are an S&P 500 indexed fund and an indexed U.S. bond fund (commonly indexed to the Bloomberg Barclays Aggregate U.S. Bond Index). Both are widely available at almost no cost, either as mutual funds or exchange traded funds.

I've survived two horrendous market crashes, the 2000 dot-com crash and the financial crisis of 2007-2008. The first was a bubble in tech stocks where the NASDAQ lost 78% of its value. The second, part of the Great Recession, was broader, with the S&P 500 dropping 56%. I suspect we are in some form of equity bubble today.

But bubbles can expand for years longer than imaginable. And they can quickly crash unceremoniously, or they may drag out poor returns for years. That is, timing what will happen in the next few years is nearly impossible.

I've vowed that I will never again be caught surprised by a crash, but here we are again. For any of you who think it is time to get out, ask yourself what you will do if the market doubles in the next few years. I've known people who waited years after the last crash for still bigger drops. They lost out on most of this current bull market.

And if  you do get out, when will you get back in? After a 20% drop? 30%? 50%? There's no guarantee any of these benchmarks will ever be reached. In fact, the market may never again be lower than it is today.

So here's my 2021 advice. Take this opportunity to familiarize yourself with your current investments and to revisit your target allocation. Understand where your costs are and where you have essentially duplicate investments. Then quickly reallocate to your plan, possibly with some consolidation of equities. Don't buy anything you don't understand and don't buy anything you aren't comfortable owning for several years.

And stay there. If the market changes dramatically, up or down, deal with the changing environment by reallocating.

For years I have done this. When markets are raging, I will occasionally and painfully sell some equities. When markets head down, I just as painfully take the opportunity to buy into a market I do not like. Occasionally, only by accident do I get it right, selling at the highest point and buying at the lowest point. But in total, I'm buying low and selling high.

When surrounded by wonderful stories of stocks doubling and more, it can be tempting to want to buy some individual stocks. Normally, the returns don't justify the risk but it's not all bad thinking. If you do, be sure you understand what you are buying and why you believe it is at least a stable investment.

If a stock drops quickly, you may want to sell before you get in too deep. If it rises, be aware that stocks can rise for a long time, even after their financials don't support it. At its worst, you may learn something about yourself. A safe place to start is the list of S&P 500 Dividend Aristocrats, the bluest of blue-chip U.S. stocks.

At a larger level, your 2021 resolution may instead be to find yourself a financial advisor who can help with all your financial needs, such as insurance, debt, kids' education, emergency funds and retirement. But like your investments, be sure you understand their fees. A danger sign is when they offer their services, including personally directly all your accounts, for free. These are normally the highest cost services, mostly hidden from you. Your best start is with a Certified Financial Planner who works on a set fee.

Good luck. And let's hope that our investments are our biggest problem in 2021!