Coverdell Education Savings Account: College with Tax Advantages
By Kevin Dufficy
The Coverdell Education Savings Accounts, once known as Education IRAs, can help taxpayers save for a child’s education. Contributions to a Coverdell ESA are nondeductible, but the earnings on the account grow tax deferred and distributions are treated as a tax-free gift to the beneficiary. The contributor does not have to be related to the beneficiary. And one contributor can set up as many individual beneficiaries as desired, there is no limit.
The federal income tax law limits Coverdell ESA contributions to $2,000 per beneficiary per year and must be in cash. Generally the contributions must be made before the beneficiary reaches age 18. In 2011, the limit decreases to $500 per beneficiary.
• Special needs: Contributions to special needs beneficiaries’ accounts may be made after the age of 18.
• Multiple accounts: More than one account may not be used to exceed the $2,000 annual limit per beneficiary.
• Excess: Contributions exceeding the $2,000 limit per beneficiary are subject to a 6% excise tax paid by the beneficiary.
• Qualified tuition programs: Contributions can be made for a beneficiary to a Section 529 or qualified tuition program (QTP) and to a Coverdell ESA are permitted in the same year.
• Income-based phase out level: For single filers, the contribution phases out when the adjusted gross income (AGI) is between $95,000 and $110,000. For married couples, filing jointly the phase-out range is between $190,000 and $220,000.
• Due dates: Contributions for the tax year must be made by the due date (not including extensions) for filing returns, generally April 15.
• Military death payment: Individuals who receive a military death gratuity or a Service members’ Group Life Insurance (SGLI) payment may contribute to a Coverdell ESA. The payment amount must not be greater than the sum of any military death gratuity and SGLI payment. Contributions are treated as rollovers and must be made within one year of receipt. The $2,000 annual limit and the phase-out limit do not apply to these types of contributions.
• Other entities: Entities such as corporations and tax-exempt organizations can contribute to a Coverdell ESA.
Generally, distributions from a Coverdell ESA are tax free and excluded from the beneficiary’s income if they are less than the qualified education expenses for the year. If the distribution exceeds the qualified expenses, then the distributed earnings will be considered taxable income and a 10% tax may be added.
• Additional tax: Any distributed earnings not used for qualified education expenses and included in beneficiary’s income are subject to a 10% tax. Exceptions that apply include beneficiary death or disability or the receipt of certain scholarships.
• Changes of beneficiary/Rollovers: Coverdell ESA beneficiaries can easily be changed, if the new beneficiary is a member of the original beneficiary’s family and has not reached age 30. The change is not treated as a taxable distribution. In addition, if a beneficiary doesn’t use the funds from their Coverdell ESA, the money may be distributed and rolled over into a new account for a different beneficiary.
The distribution is not taxable to the original beneficiary if:
o The rollover occurs within 60 days of the distribution.
o The new beneficiary is a member of the original beneficiary’s family.
o The new beneficiary is not yet age 30.
• Beneficiary reaches age 30: When a beneficiary reaches age 30, any remaining funds in a Coverdell ESA must be distributed and are subject to an additional 10% tax for that year. If a beneficiary dies before age 30, any remaining balance in the account becomes taxable and must be distributed to the estate within 30 days of death.
• Special needs beneficiaries: A special needs individual age 30 or older may be a beneficiary of a Coverdell ESA and an account rollover.
• Effect on financial aid eligibility: If the Coverdell ESA is owned by the parent of a dependent student, then the impact on the eligibility for financial aid is low. When the account owner is the student, this has high impact on the financial aid eligibility. In the financial aid determination process, the tax-free distributions from the Coverdell ESA are not counted as income to either the parent or the student.
However, regardless who owns the account, private institutions may consider Coverdell ESA assets and income when awarding their financial aid.
• Impact on federal bankruptcy: Federal bankruptcy law can protect a portion or all of the assets in a Coverdell ESA from creditors.
• Future federal legislative changes: Most of the provisions affecting Coverdell ESAs under the Economic Growth and Tax Relief Reconciliation Act (EGTRRA) of 2001, will expire after 2010, when prior law will be reinstated.
• Loss of control: Donors to the Coverdell ESA may not “take back” the account. The funds will eventually pass to the beneficiary.
• Losses: If certain requirements are met, a loss can be taken on your federal income tax return.
Coverdell ESAs offer a tax-favored situation that allows funds to accumulate to pay for a beneficiary’s qualified education expenses.
Contributions to a Qualified Tuition Plan under IRC Section 529 are considered allowable expenses. Depending on the education level, the qualified education expense definitions and the allowed educational institutions will change:
• Kindergarten to Grade 12: The term “school” refers to an institution that provides elementary or secondary education, under state law. This may be a public, private, or religious school.
Qualified education expenses refer to:
Tuition, fees, academic tutoring, services for special needs individuals, books, supplies, and equipment. Room and board, uniforms, transportation, and supplemental services such as extended day programs also qualify as education expenses. In specified circumstances qualified expense also include: computer equipment and technology, including software and Internet connections.
• Post-secondary: The term “eligible educational institution” generally refers to accredited post-high school educational institutions offering associates, bachelors, graduate level, or professional degrees. Certain vocational schools are also included.
Qualified education expenses refer to:
Tuition, fees, books, and supplies and equipment needed for attendance. For students attending half time or more, room and board is included.
• Family member: Coverdell ESA assets may be transferred between family members. In addition to spouse family members include:
o Son or daughter, or their descendents
o Stepson or stepdaughter
o Brother, sister, stepbrother, or stepsister
o Father or mother or ancestor of either
o Stepfather or stepmother
o Son or daughter of a brother or sister
o Brother or sister of father or mother
o Spouse of any person listed above
o First cousins
About Kevin Dufficy
Kevin Dufficy is a seasoned financial expert having written articles and blogs on a wide range of financial, investment and retirement planning topics. He has an MBA from UC Berkeley, and a degree from H.E.C., the leading French business school in Paris, France. To follow Kevin"s profile, click here.