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Coverdell Education Savings Account (ESA)

A Coverdell Education Savings Account (ESA) is one type of Educational Program Account. This topic provides a comprehensive description of it as defined under Section 530 of the Internal Revenue Code (IRC).

For a discussion of eligibility implications for Supplemental Security Income (SSI) recipients that may come into play when these accounts are established, funded, or funds are distributed from them, see the Educational Program Accounts topic.

You may read this topic in sequence or jump to a specific section:

·              Introduction

o                      What is the tax benefit of the Coverdell ESA?

·              What Is a Coverdell ESA?

·              Qualified Education Expenses

o                      Designated beneficiary

·              Eligible Educational Institution

o                      Eligible postsecondary school

o                      Eligible elementary or secondary school

·              Qualified Higher Education Expenses

·              Qualified Elementary and Secondary Education Expenses

·              Contributions

·              Contribution Limits

o                      Limit for each designated beneficiary

o                      Limit for each contributor

·              Additional Tax on Excess Contributions

o                      Exceptions

·              Distributions

o                      Adjusted qualified education expenses

o                      Tax-Free Distributions

o                      Taxable Distributions

o                      Additional Tax on Taxable Distributions

o                      When Assets Must Be Distributed

·              Coordination With Hope and Lifetime Learning Credits

·              Coordination With Qualified Tuition Program (QTP) Distributions

Introduction

Coverdell Education Savings Accounts (ESA) were formerly known as Education Individual Retirement Accounts (IRA).

If your modified adjusted gross income (MAGI) is less than $110,000 ($220,000 if filing a joint return), you may be able to establish a Coverdell Education Savings Account (ESA) to finance the qualified education expenses of a designated beneficiary. For most taxpayers, MAGI is the adjusted gross income as figured on their federal income tax return.

There is no limit on the number of separate Coverdell ESAs that can be established for a designated beneficiary. However, total contributions for the beneficiary in any year cannot be more than $2,000, no matter how many accounts have been established. See Contributions, below.

This benefit applies not only to higher education expenses, but also to elementary and secondary education expenses.

What is the tax benefit of the Coverdell ESA?

Contributions to a Coverdell ESA are not deductible, but amounts deposited in the account grow tax free until distributed.

If, for a year, distributions from an account are not more than a designated beneficiary's qualified education expenses at an eligible educational institution, the beneficiary will not owe tax on the distributions. See Tax-Free Distributions, below.

What Is a Coverdell ESA?

A Coverdell ESA is a trust or custodial account created or organized in the United States only for the purpose of paying the qualified education expenses of the designated beneficiary of the account.

When the account is established, the designated beneficiary must be under age 18 or a special needs beneficiary.

To be treated as a Coverdell ESA, the account must be designated as a Coverdell ESA when it is created.

The document creating and governing the account must be in writing and must satisfy the following requirements:

·              The trustee or custodian must be a bank or an entity approved by the IRS.

·              The document must provide that the trustee or custodian can only accept a contribution that meets all of the following conditions:

o                      The contribution is in cash.

o                      The contribution is made before the beneficiary reaches age 18, unless the beneficiary is a special needs beneficiary.

o                      The contribution would not result in total contributions for the year (not including rollover contributions) being more than $2,000.

·              Money in the account cannot be invested in life insurance contracts.

·              Money in the account cannot be combined with other property except in a common trust fund or common investment fund.

·              The balance in the account generally must be distributed within 30 days after the earlier of the following events:

o                      The beneficiary reaches age 30, unless the beneficiary is a special needs beneficiary.

o                      The beneficiary's death.

Qualified Education Expenses

Generally, these are expenses required for the enrollment or attendance of the designated beneficiary at an eligible educational institution. For purposes of Coverdell ESAs, the expenses can be either qualified higher education expenses or qualified elementary and secondary education expenses.

Designated beneficiary

This is the individual named in the document creating the trust or custodial account to receive the benefit of the funds in the account.

Eligible Educational Institution

For purposes of Coverdell ESAs, an eligible educational institution can be either an eligible postsecondary school or an eligible elementary or secondary school.

Eligible postsecondary school

This is any college, university, vocational school, or other postsecondary educational institution eligible to participate in a student aid program administered by the U.S. Department of Education. It includes virtually all accredited public, nonprofit, and proprietary (privately owned profit-making) postsecondary institutions. The educational institution should be able to tell you if it is an eligible educational institution.

Certain educational institutions located outside the United States also participate in the U.S. Department of Education's Federal Student Aid (FSA) programs.

Eligible elementary or secondary school

This is any public, private, or religious school that provides elementary or secondary education (kindergarten through grade 12), as determined under state law.

Qualified Higher Education Expenses

These are expenses related to enrollment or attendance at an eligible postsecondary school. As shown in the following list, to be qualified, some of the expenses must be required by the school and some must be incurred by students who are enrolled at least half time. Contributions to qualified tuition programs can be qualified education expenses.

·              The following expenses must be required for enrollment or attendance of a designated beneficiary at an eligible postsecondary school:

o                      Tuition and fees.

o                      Books, supplies, and equipment.

·              Expenses for special needs services needed by a special needs beneficiary must be incurred in connection with enrollment or attendance at an eligible postsecondary school.

·              Expenses for room and board must be incurred by students who are enrolled at least half time.

The expense for room and board qualifies only to the extent that it is not more than the greater of the following two amounts:

o                      The allowance for room and board, as determined by the school, that was included in the cost of attendance (for federal financial aid purposes) for a particular academic period and living arrangement of the student.

o                      The actual amount charged if the student is residing in housing owned or operated by the school.

·              Any contribution to a qualified tuition program (QTP) must be on behalf of the designated beneficiary of the Coverdell ESA. In the case of a change in beneficiary, this is a qualified expense only if the new beneficiary is a family member of that designated beneficiary. (See Qualified Tuition Program (QTP).)

Qualified Elementary and Secondary Education Expenses

These are expenses related to enrollment or attendance at an eligible elementary or secondary school. As shown in the following list, to be qualified, some of the expenses must be required or provided by the school. There are special rules for computer-related expenses.

·              The following expenses must be incurred by a designated beneficiary in connection with enrollment or attendance at an eligible elementary or secondary school:

o                      Tuition and fees.

o                      Books, supplies, and equipment.

o                      Academic tutoring.

o                      Special needs services for a special needs beneficiary.

·              The following expenses must be required or provided by an eligible elementary or secondary school in connection with attendance or enrollment at the school:

o                      Room and board.

o                      Uniforms.

o                      Transportation.

o                      Supplementary items and services (including extended day programs).

·              The purchase of computer technology, equipment, or Internet access and related services is a qualified elementary and secondary education expense if it is to be used by the beneficiary and the beneficiary's family during any of the years the beneficiary is in elementary or secondary school. (This does not include expenses for computer software designed for sports, games, or hobbies unless the software is predominantly educational in nature.)

Contributions

Any individual (including the designated beneficiary) can contribute to a Coverdell ESA if the individual's modified adjusted gross income (MAGI) for the year is less than $110,000. For individuals filing joint returns, that amount is $220,000. For most taxpayers, MAGI is adjusted gross income (AGI) as figured on their federal income tax return.

Organizations, such as corporations and trusts, can also contribute to Coverdell ESAs. There is no requirement that an organization's income be below a certain level.

Contributions must meet all of the following requirements:

·              They must be in cash.

·              They cannot be made after the beneficiary reaches age 18, unless the beneficiary is a special needs beneficiary, and

·              They must be made by the due date of the contributor's tax return (not including extensions).

Contributions can be made to one or several Coverdell ESAs for the same designated beneficiary provided that the total contributions are not more than the contribution limits (defined later) for a year.

Contributions can be made, without penalty, to both a Coverdell ESA and a Qualified Tuition Program (QTP) in the same year for the same beneficiary.

Contribution Limits

There are two yearly limits:

·              One on the total amount that can be contributed for each designated beneficiary in any year, and

·              One on the amount that any individual can contribute for any one designated beneficiary for a year.

Limit for each designated beneficiary

The total of all contributions to all Coverdell ESAs set up for the benefit of any one designated beneficiary cannot be more than $2,000. This includes contributions (other than rollovers) to all the beneficiary's Coverdell ESAs from all sources.

Limit for each contributor

Generally, you can contribute up to $2,000 for each designated beneficiary. This is the most you can contribute for the benefit of any one beneficiary for the year, regardless of the number of Coverdell ESAs set up for the beneficiary.

Additional Tax on Excess Contributions

The beneficiary must pay a 6% excise tax each year on excess contributions that are in a Coverdell ESA at the end of the year. Excess contributions are the total of the following two amounts:

·              Contributions to any designated beneficiary's Coverdell ESA for the year that are more than $2,000 (or, if less, the total of each contributor's limit for the year, as discussed earlier).

·              Excess contributions for the preceding year, reduced by the total of the following two amounts:

o                      Distributions (other than those rolled over as discussed later) during the year, and

o                      The contribution limit for the current year minus the amount contributed for the current year.

Exceptions

The excise tax does not apply if excess contributions made during one year (and any earnings on them) are distributed before the first day of the sixth month of the following tax year (June 1, for a calendar year taxpayer).

Note: Contributions made in one year for the preceding taxable year are considered to have been made on the last day of the preceding year.

Distributions

The designated beneficiary of a Coverdell ESA can take a distribution at any time. Whether the distributions are tax free depends, in part, on whether the distributions are equal to or less than the amount of adjusted qualified education expenses (defined below) that the beneficiary has in the same tax year.

Adjusted qualified education expenses

To determine if total distributions for the year are more than the amount of qualified education expenses, reduce total qualified education expenses by any tax-free educational assistance. Tax-free educational assistance includes:

·              The tax-free part of scholarships and fellowships,

·              Veterans' educational assistance,

·              Pell grants,

·              Employer-provided educational assistance, and

·              Any other nontaxable (tax-free) payments (other than gifts or inheritances) received as educational assistance.

The amount you get by subtracting tax-free educational assistance from your total qualified education expenses is your adjusted qualified education expenses.

Tax-Free Distributions

Generally, distributions are tax free if they are not more than the beneficiary's adjusted qualified education expenses for the year.

Taxable Distributions

A portion of the distributions is generally taxable to the beneficiary if the distributions are more than the beneficiary's adjusted qualified education expenses for the year.

Additional Tax on Taxable Distributions

Generally, if you receive a taxable distribution, you also must pay a 10% additional tax on the amount included in income. There are a number of exceptions to this rule.

One of the exceptions provides that the 10% additional tax does not apply to distributions made because the designated beneficiary is disabled. A person is considered to be disabled if he or she shows proof that he or she cannot do any substantial gainful activity because of his or her physical or mental condition. A physician must determine that his or her condition can be expected to result in death or to be of long-continued and indefinite duration.

When Assets Must Be Distributed

Any assets remaining in a Coverdell ESA must be distributed when either one of the following two events occurs:

·              The designated beneficiary reaches age 30. In this case, the remaining assets must be distributed within 30 days after the beneficiary reaches age 30. However, this rule does not apply if the beneficiary is a special needs beneficiary.

·              The designated beneficiary dies before reaching age 30. In this case, the remaining assets must generally be distributed within 30 days after the date of death.

Coordination With Hope and Lifetime Learning Credits

The Hope or Lifetime Learning Credit can be claimed in the same year the beneficiary takes a tax-free distribution from a Coverdell ESA, as long as the same expenses are not used for both benefits. This means the beneficiary must reduce qualified higher education expenses by tax-free educational assistance, and then further reduce them by any expenses taken into account in determining a Hope or Lifetime Learning Credit.

Coordination With Qualified Tuition Program (QTP) Distributions

If a designated beneficiary receives distributions from both a Coverdell ESA and a Qualified Tuition Program (QTP) in the same year, and the total distribution is more than the beneficiary's adjusted qualified higher education expenses, those expenses must be allocated between the distribution from the Coverdell ESA and the distribution from the QTP before figuring how much of each distribution is taxable.

Also see:

Educational Program Accounts

Qualified Tuition Program (QTP or "529 Plan")

Source

IRS Publication 970, Tax Benefits for Education, Chapter 7, available at:
http://www.irs.gov/publications/p970/ch07.html

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