Coverdell Education Savings Accounts

Last major update: 04/21/08

Introduction
A Coverdell Education Savings Account (ESA) is a tax deferred account dedicated to saving for education expenses. This benefit applies to both qualified higher education expenses as well as to qualified elementary and secondary education expenses. Similar to a Roth IRA, contributions to a Coverdell ESA are not deductible, but amounts deposited in the account grow tax free until distributed. The beneficiary will not owe tax on the distributions if they are less than a beneficiary’s qualified education expenses at an eligible institution. For a contribution to be eligible under the program, the beneficiary must be under age 18 or else qualify as a special needs beneficiary. The ESA must distribute all funds to the beneficiary by age 30, although the beneficial interest in the ESA can always be transferred to another qualifying beneficiary. The total contributions for a beneficiary are limited to $2,000 in any year, no matter how many accounts have been established. If one has more than one beneficiary, separate accounts can be established for each beneficiary, with each beneficiary subject to a $2,000 annual contribution limit. There are income limits applying to contributors to a Coverdell ESA. These limits can effect the annual $2,000 limit:
 * To make a full $2,000 contribution, married couples filing jointly can have a modified adjusted gross income of up to $190,000; single filers, up to $95,000.
 * To make a partial contribution, married couples filing jointly can have a modified adjusted gross income of $190,000 to $220,000; single filers, $95,000 to $110,000.

Anyone, including grandparents, parents, children, and relatives can contribute into a Coverdell ESA for a beneficiary, provided that no more than the annual $2,000 dollar limit is contributed and that all contributors fall within income limitations. Special care must be taken for multiple accounts established for a beneficiary by different donors (for example, a parent and a grandparent) that the $2,000 annual limit is not exceeded, since excess contributions are subject to a 6% excise tax.

One distinct advantage the Coverdell ESA has over other educational savings programs is that the individual creating the account can select the fiduciary and management firm that will hold and invest the funds deposited into the program. An investor is free to chose a low cost investment firm with a wide selection of investment choices. Details on the Vanguard Coverdell Education Savings Account are covered in a separate page.

Account Ownership
The Coverdell ESA is structured as a trust or custodial account for a beneficiary. The funds invested must be administered and distributed for the benefit of the beneficiary. Because the beneficiary is usually a minor, a "responsible individual," almost invariably a parent or guardian, must administer the account. In this context it is important to point out that grandparents or relatives establishing an ESA for a grandchild or nephew/niece must name the parent or guardian of the child beneficiary the responsible agent. Contributions to a Coverdell ESA are considered gifts that qualify under the annual $12,000 gift tax exclusion.

Distributing The Account
Distributions from a Coverdell ESA are tax free if they are used for qualifying educational expenses. Qualified expenses include:
 * tuition, room and board;
 * fees, books, supplies, and computer-related technology equipment.

When applying for federal financial aid, the ESA account is considered an asset of the account custodian, typically the parent.

Distributions from an ESA can be combined with the Hope and Lifetime Learning tax credits to cover qualified education costs, but the same cost can not be covered by both the ESA and the credit. The combination of disbursements and credits may make a portion of the disbursement taxable to the beneficiary. Generally, if distributions are in excess of qualified expenses, the beneficiary pays income tax on the earnings plus a 10% penalty tax. The penalty tax is waived in the instances of:
 * Death or disability of the beneficiary;
 * The beneficiary receives an income scholarship; pell grant, or benefits under a qualifying employer-provided educational assistance program;
 * The part of a distribution made taxable by using the Hope and Lifetime earnings credits.

The Coverdell ESA must generally be distributed within 30 days of the beneficiary reaching age 30, The portion representing earnings on the account will be taxable and subject to the additional 10% tax. The beneficiary may avoid these taxes by rolling over the full balance to another family member under the age of thirty. In cases of death, the account is distributed to the estate of the beneficiary and income tax is owed on the earnings, with no penalty tax. The income tax can be avoided by changing the beneficiary to a surviving spouse or other qualifying family member. As these tax factors can become quite involved, one should consult IRS Publication 970 for details.

Tax Documents
For any year in which you make a contribution, rollover, or trustee to trustee transfer into a Coverdell ESA you should receive a Form 5498-ESA from your investment company fiduciary:
 * Form 5498-ESA (2008)
 * Instructions for Form 5498-ESA (2008)

For any year in which a distribution is made from the ESA, the beneficiary should receive a Form 1009-Q from your investment company fiduciary:
 * Form 1009-Q (2008)
 * Instructions for Form 1099-Q (2008)

Comparison to 529 Plans
The following chart, courtesy of Vanguard, compares the ESA with the 529 plan:

† Earnings on nonqualified withdrawals may be subject to federal income tax and a 10% federal penalty tax, as well as state and local income taxes. The availability of tax or other benefits may be contingent on meeting other requirements.

†† Distributions for qualified educational expenses are not counted as parent or student income in the determination of federal financial aid eligibility. Individuals should consult their advisors about the financial aid treatment of student-owned and UGMA/UTMA 529 accounts.

††† If you choose to take advantage of the accelerated gift tax benefit and you die within 5 years, a prorated portion of the contribution will be subject to estate tax. If you contribute more than $12,000 in a particular year, you must file IRS Form 709 by April 15 of the following year. For more information, consult your tax advisor or estate planning attorney.

Special Caution
The current regulations governing Coverdell ESA's are set to expire in 2010, unless Congress acts. Assuming no action, the following ESA benefit changes will occur:
 * K-12 expenses will no longer qualify;
 * The annual contribution limit will be reduced to $500;
 * Withdrawals will not be tax-free in any year in which a Hope credit or Lifetime credit or Lifetime Learning credit is claimed for the beneficiary