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Coverdell Education Savings Accounts
Coverdell Education Savings Accounts (ESAs) were previously known as
Education IRAs. They were originally established by the Taxpayer
Relief Act of 1997 (P.L. 105-34), and then subsequently expanded by
the Economic Growth and Tax Relief Reconciliation Act of 2001,
P.L. 107-16 (EGTRRA).
Unlike section 529 college savings plans and prepaid tuition plans,
which are restricted to postsecondary education, Coverdell Education
Savings Accounts may be used to save for private K-12 schools in
addition to college.
The Tax Relief, Unemployment Insurance Reauthorization, and Job
Creation Act of 2010 (P.L. 111-312) extended section 401 of the Economic
Growth and Tax Relief Reconciliation Act of 2001 for two years. This
allows families to continue to use Coverdell Education Savings
Accounts to pay for private K-12 school expenses until December 31,
2012.
Characteristics of Coverdell Education Savings Accounts
Coverdell accounts are trusts created exclusively for the purpose of
paying the qualified education expenses of the designated beneficiary
of the trust. They are exempt from federal taxation and have the
following characteristics:
- Contribution Amount: Maximum of $2,000 per beneficiary from all
sources per year. (There is an exception for contributions resulting
from a rollover.)
- Account Ownership: Coverdell accounts may be owned by the
student or the student's parent.
- Contribution Age Limit: Contributions may be made until the
beneficiary reaches age 18.
- Withdrawal Age Limit: The money must be used by the time the
child reaches age 30 or the earnings will be taxed as ordinary income
plus a 10% penalty.
- Exceptions: There are no age limits for special needs
beneficiaries.
- Rollovers: Coverdell accounts may be rolled over to the Coverdell
acount of a family member of the previous beneficiary.
- Income Phaseouts: Contributions are phased out for incomes between
$95,000 and $110,000 (single filers) or $190,000 and $220,000 (married
filing jointly). (These phaseouts may potentially be bypassed by
giving money to the child through an UGMA/UTMA custodial account and
having the child contribute to his or her own Coverdell account.)
- Corporations May Contribute: Corporations, including tax-exempt
organizations, may contribute to an individual's Coverdell account,
regardless of income level.
- Contributions in Cash: Contributions must be in the form of
cash. Contributions of stocks, bonds, and other savings vehicles are
not permitted.
- Investment Restrictions: No part of trust assets may be invested
in life insurance contracts. However, investment options are not otherwise as
limited as those offered by section 529 plans.
- Income Tax Implications: Contributions are not deductible on
federal or state income tax, but earnings accumulate tax-free.
Qualified distributions are exempt from federal income tax.
Contributions may be made until the due date of the contributor's tax
return (normally April 15 of the following year).
Non-qualified withdrawals are taxed as
ordinary income at donor's rate and subject to a 10% tax penalty.
(Non-qualified distributions remain tax-free in cases of death or
disability of the beneficiary.)
- Estate Tax Implications: Contributions are removed from the
donor's gross estate but included in the beneficiary's gross estate.
- Qualified Expenses: Primary, secondary, and postsecondary education
expenses, including tuition, fees, tutoring, books, supplies, related
equipment, room and board, uniforms, transportation and computers.
- Qualified Education Expenses: Coverdell Education Savings
Accounts can also be used to pay for private elementary, middle and
secondary school education as well as higher education expenses.
There are also several characteristics that relate to using a
Coverdell Education Savings Account for college expenses.
- Financial Aid Impact: Treated as an asset of the account
owner for federal student aid purposes. If the account owner is the
student, this has a high impact on
financial aid eligibility. (But note that the Higher Education
Reconciliation Act of 2005 added special treatment for Coverdell,
Prepaid Tuition and 529 College Savings Plan accounts owned by a
dependent student. The impact on need-based aid for dependent
students will therefore be minimal.) If the account owner is the parent, this
has a low impact on financial aid eligibility. Qualified distributions
from a Coverdell account are not counted as income on the Free
Application for Federal Student Aid (FAFSA) and
thus do not reduce financial aid eligibility.
- Coordination with Section 529 Plans: You can contribute to both
a Coverdell account and a section 529 plan in the same year, but there
may be gift tax implications if you give more than the annual gift tax
exclusion ($13,000 in 2010) per beneficiary.
- Coordination with Education Tax Credits: You can claim a Hope
Scholarship and/or Lifetime Learning tax credit in the same year as
you withdraw funds from a Coverdell Account, so long as the credits
are claimed using different qualified education expenses than those
paid from the Coverdell distribution. You can't use the same
expenses to justify two different programs.
Dear Colleague Letter GEN-04-02 from the US Department of Education
clarified the financial aid treatment of Coverdell Education Savings
Accounts.
Some Provisions Sunset on December 31, 2012
Certain provisions of the Economic Growth and Tax Relief
Reconciliation Act of 2001 are scheduled to sunset on December 31,
2012. (Note that the EGTRRA improvements made permanent by the Pension
Protection Act of 2006 (P.L. 109-280) appear in section 402 of
EGTRRA. The improvements relating to Coverdell appear in section 401
of EGTRRA.) These include:
- The addition of elementary and secondary school expenses to the
definition of qualified education expenses.
- Increasing the maximum contribution from $500 to $2,000.
- Increases in the income phaseout for married couples.
- Improvements in the coordination with section 529 plans and
education tax credits.
Note: Computers are included as a qualified expense for students in
elementary and secondary schools even if they are not required by the
school. For students enrolled in postsecondary institutions, however,
computers are allowed as a qualified expense only if required by the school.
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