Common Questions about Coverdell Education Savings Accounts

What are Coverdell Education Savings Accounts?

Coverdell Education Savings Accounts are a way to save money for college. Coverdell's provide special tax advantages not otherwise available through general savings. These accounts are governed by Section 530 of the Internal Revenue Code¹ and are named for Senator Paul Coverdell, who sponsored the legislation that established these accounts in the tax code.

Coverdell Education Savings Accounts allow custodians to set up accounts for a beneficiary. The custodian who sets up the account can be anyone, but is usually a parent or grandparent. The beneficiary can be anyone as long as the beneficiary is either under 18 years' old or special needs. The beneficiary is usually a child or grandchild. In other words, parents or grandparents can set up Coverdell Education Savings Accounts on behalf of their children or grandchildren.

The custodian can make contributions of up to $2,000 per beneficiary per year. These contributions are not tax-deductible, but the earnings of the account grow tax-free. As long as distributions (or withdrawals of money) from the account are used to pay for “qualified education expenses”, no taxes will be owed on the money distributed.²

Are there limitations on contributions made to Coverdell Education Savings Accounts?

Coverdell Education Savings Accounts have several contribution limitations to keep in mind, as discussed below.

Modified Adjusted Gross Income (MAGI) Limits

Your MAGI on your federal income tax return must be less than $110,000, or $220,000 if filing jointly, to contribute to a Coverdell Education Savings Account.³

Age Limits

The beneficiary of Coverdell Education Savings Accounts must be younger than 18 when the account is established, and no contributions can be made after the beneficiary reaches age 30, unless the beneficiary is special needs.⁴

Investment Limits

Contributions must be made in cash. Also, the contributions cannot be invested in life insurance contracts.⁵

Annual Contribution Amount

Contributions cannot be more than $2,000 per year per beneficiary. If the beneficiary has more than one Coverdell Education Savings Account, the contributions to all accounts in total cannot exceed $2,000. For example, if Susan's grandparents establish one Coverdell Education Savings Account for her, and her parents establish another, the total contributions made by both her grandparents and parents cannot exceed $2,000. So if her grandparents contribute $2,000 to their Coverdell Education Savings Account in 2007, her parents can contribute nothing in 2007.⁶

Date Limits

Contributions for a certain year can be made until the due date of the tax return. For example, if Susan's parents want to make a contribution to her Coverdell Education Savings Account in 2007, they have until April 15, 2008, to deposit the money in the Coverdell.⁷

What happens if more than the $2,000 limit is contributed?

The beneficiary of the Coverdell Education Savings Account will owe a 6% tax on the amount of contributions above $2,000.⁸ So if Susan's parents contribute $3,000 to her Coverdell Education Savings Account in 2007, Susan will owe a 6% tax on the excess $1,000.

Is there a time when the money in a Coverdell Education Savings Account must be withdrawn, or can it remain in the Coverdell indefinitely?

No, the money cannot remain in the Coverdell Education Savings Account indefinitely. Any remaining money in a Coverdell Education Savings Account must be withdrawn when the beneficiary reaches age 30 or when the beneficiary dies. The one exception to the age rule is if the beneficiary is special needs. There is no age when the money must be withdrawn for a special needs beneficiary.⁹

However, the Coverdell Education Savings Account can be rolled over or transferred to another beneficiary, as long as the new beneficiary meets certain requirements discussed in the next two questions.

How are rollovers treated?

To be considered a rollover, distributions from one Coverdell Education Savings Account must be deposited into another Coverdell Education Savings Account within 60 days of the date of the distribution. The beneficiary of the Coverdell Education Savings Account which the distribution is rolled into must be in the same family as the other beneficiary. Such rollovers are not subject to taxes.

A member of the family is considered any of the following:

1. Child or descendant of a child.
2. Brother, sister, stepbrother, or stepsister.
3. Father or mother or ancestor of either.
4. Stepfather or stepmother.
5. Son or daughter of a brother or sister.
6. Brother or sister of father or mother.
7. Son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, or sister-in-law.
8. The spouse of any individual listed above.
9. First cousin.¹⁰

Can the designated beneficiary of a Coverdell Education Savings Account be changed?

Yes, the designated beneficiary can be changed as long as the new beneficiary is under age 30, or any age if special needs.¹¹ For example, Susan graduates from college and has $5,000 left in her Coverdell Education Savings Account. Her brother James is still in college. James can be named as the designated beneficiary of Susan's Coverdell Education Savings Account, and as such he can use the $5,000 to pay for his qualified education expenses.

What exactly does “special needs” beneficiary mean?

Unfortunately, “special needs” is vague and undefined in the tax code. It is generally thought to mean a beneficiary who is disabled, but until the definition is cleared up in the regulations, this will continue to be an area of ambiguity.¹²

What is a qualified education expense?

To be a qualified education expense, the money must be:

1. paid to a qualified institution, and
2. used to pay for specific education expenses incurred by attending a qualified institution.

Higher Education Expenses

Institutions that qualify include any university, vocational school, or other postsecondary educational institution that can or does participate in a Department of Education student aid program.

Qualified education expenses include:

1. Tuition
2. Fees
3. Books
4. Supplies
5. Equipment
6. Room
7. Board
8. Any expenses for special needs services.

To qualify for room and board expenses, the student must be enrolled at least “half-time”.¹³

Elementary and Secondary Expenses

An eligible elementary or secondary institution includes any public, private, or religious school that provides elementary or secondary education as recognized by your state's laws.

Qualified education expenses include:

1. Tuition
2. Fees
3. Books
4. Supplies
5. Equipment
6. Tutoring
7. Special needs services.

If the following expenses are mandatory, they are considered qualified education expenses:

1. Room
2. Board
3. Uniforms
4. Transportation
5. Supplementary items and services.

Computer expenses qualify if the expenses are used by the beneficiary during the years he is in elementary or secondary school.¹⁴

What is a distribution from a Coverdell Education Savings Account ?

A distribution is a withdrawal of money from the Coverdell Education Savings Account. Any amount of money can be withdrawn at any time; however, taxes will be owed on the money withdrawn unless the money is used to pay for “qualified education expenses”. If all money withdrawn is used to pay for these expenses, no taxes will be owed. If part of the money is used to pay for these expenses, taxes will be owed on the other part. If none of the money is used to pay for these expenses, taxes will be owed on all the money.¹⁵

What if my child receives a scholarship or other money to pay for college expenses? How will that affect the Coverdell Education Savings Account distributions?

If the beneficiary of a Coverdell Education Savings Account receives scholarships or other tuition assistance to pay for education expenses, Coverdell distributions covering the rest of the expenses will still be tax-free.

For example, Susan's tuition, fees, and books at State University in 2007 totaled $10,000. Susan received a $2,000 scholarship, leaving $8,000 in “adjusted qualified education expenses” which Susan, or her parents, must pay. If Susan receives an $8,000 distribution from her Coverdell Education Savings Account to pay these remaining expenses, she will owe no taxes on the distribution. However, if Susan takes a $9,000 distribution, she will owe taxes on the $1,000 of the distribution in excess of the remaining $8,000 adjusted qualified education expenses.¹⁶

What taxes will be owed on Coverdell Education Savings Account distributions that do not pay for adjusted qualified education expenses?

A taxable Coverdell Education Savings Account distribution is also subject to a 10% tax penalty. For example, if Susan's adjusted qualified education expenses to State University in 2007 are $8,000, and she receives a $9,000 Coverdell Education Savings Account distribution, she will owe a $100 tax penalty on the excess $1,000.

There are some exceptions to the 10% tax penalty. The 10% tax will not be owed if the distribution is:

1. Paid to a beneficiary (or to the estate of the designated beneficiary) on or after the death of the designated beneficiary.
2. Made because the designated beneficiary is disabled.
3. Included in income because the designated beneficiary received:
1. A tax-free scholarship or fellowship,
2. Veterans' educational assistance,
3. Employer-provided educational assistance, or
4. Any other nontaxable (tax-free) payments (other than gifts or inheritances) received as educational assistance.
4. Made on account of the attendance of the designated beneficiary at a U.S. military academy (such as West Point).
5. Included in income only because the qualified education expenses were taken into account in determining the Hope or lifetime learning credit.
6. Made before June 1, 2007, of an excess 2006 contribution (and any earnings on it). The distributed earnings must be included in gross income for the year in which the excess contribution was made. ¹⁷

Can the Hope or Lifetime Learning tax credit be taken when distributions from a Coverdell Education Savings Account are used to pay for education expenses?

Maybe. As long as the credits and the Coverdell Education Savings Account distribution are not used to pay for the same expenses, the credits can be taken. The calculations can get fairly involved, so check with your financial advisor for more details about your specific situation.¹⁸

How is a Coverdell Education Savings Account different from a 529 plan?

529 plans are set up and administered by the states, but Coverdell Education Savings Accounts are individual savings accounts that are invested in consultation with your financial advisor. 529 plans cover only higher education expenses, while Coverdell Education Savings Account distributions can be used to pay for elementary, secondary, or higher education expenses. Also, 529 plans generally do not have contribution limitations, while Coverdell Education Savings Accounts do. In addition, 529 plans can have very stringent rules, especially if the 529 is a prepaid tuition plan. Coverdell Education Savings Accounts offer more flexibility since the plans are not tied to a specific state or higher education institution. To know whether a 529 or Coverdell Education Savings Account is right for your family, discuss your specific situation with your financial advisor.

This article has explained the basic rules governing Coverdell Education Savings Accounts. It is not meant to be a comprehensive guide to all aspects of Coverdell Education Savings Accounts, so for more information about your specific situation, contact your financial advisor.

References

United States Internal Revenue Service, Publication 970, Chapter 7, Coverdell Education Savings Accounts (ESA), http://www.irs.gov/publications/p970/ch07.html

United States Internal Revenue Service, Tax Topic 310, Coverdell Education Savings Accounts, http://www.irs.gov/taxtopics/tc310.html

United States Code, Title 26, Subtitle A, Chapter 1, Subchapter F, Part VIII, Section 530, Coverdell Education Savings Accounts, http://www.law.cornell.edu/uscode/html/uscode26/usc_sec_26_00000530----000-.html