Coverdell Education Savings Accounts

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A Coverdell Education Savings Account (ESA), established by Section 530 in the IRS Code[1], 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.

Contributions

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.[2]

Advantages

  • Tax free growth similar to a Roth IRA.
  • 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, which is distinct over other educational savings programs. Details on the Vanguard Coverdell Education Savings Account are covered in a separate page.[3]

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 $14,000 gift tax exclusion (as of 2013).[4] Note this means that in years in which a Coverdell contribution is made for somebody's benefits, other gifts (such as 529's) to that beneficiary should be appropriately reduced if one wishes to avoid the gift tax.

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 American Opportunity [5] and Lifetime Learning [6] tax credits to cover qualified education costs, but the same cost can not be covered by both the ESA and the credit [7]. 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.[8]

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 [9] 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:

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:

Comparison to 529 plans

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

529 College Savings Plan Education Savings Account
What Can You Do Invest Tax Free for college† Invest up to $2,000 tax-free for any education level
Ability to change beneficiaries Yes Yes
Controlled by Person Establishing the account Person Establishing the account
Uses Qualified college expenses Primary, secondary, or higher education
Impact on federal financial aid eligibility Considered asset of parent or other account owner†† Considered asset if parent, if account owner
Contributions state tax-deductible Varies by state No
State tax on earnings Varies by state Varies by state
Federal tax on earnings No† No, if used for qualified expenses
Penalties for nonqualified withdrawals Federal income tax plus 10% penalty
State penalties vary
Federal income tax plus 10% penalty
State penalties vary
Contribution maximum per beneficiary $200,000 to $300,000 or more, depending on state $2,000 per year
Investment options Portfolios consisting of a variety of securities Any non-insurance securities
Estate planning impact Contribution are removed from estate††† Contributions are immediately removed from estate
Income limitations No Yes

† 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 $14,000 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.

See also

References

External links