Coverdell Education Savings Accounts (Coverdell ESAs) are one of three types of qualified education benefits, the other types being 529 college savings plans and prepaid tuition plans. Distributions from a Coverdell education savings account are tax-free if used to pay for qualified education expenses subject to certain additional restrictions. Coverdell ESAs were previously known as Education Individual Retirement Accounts (Education IRAs).
Coverdell education savings accounts are eligible for a broader range of investment options than 529 college savings plans. Investors can choose to invest in individual stocks and bonds, not just in a limited selection of mutual funds. (Investments are not permitted in life insurance contracts.)
Tax Treatment of Distributions
Contributions to a Coverdell education savings account are made with after-tax dollars. Earnings within a Coverdell ESA occur on a tax-deferred basis.
Distributions are tax-free if used to pay for qualified education expenses. Qualified education expenses include the same qualified higher education expenses as 529 college savings plans, qualified elementary and secondary school expenses, and rollovers into a 529 college savings plan or prepaid tuition plan for the same beneficiary. Qualified higher education expenses include tuition, fees, books, supplies, equipment, and, if enrolled on at least a half-time basis, room and board. Qualified elementary and secondary school expenses include tuition, fees, academic tutoring, special needs services, books, supplies, equipment, room and board, uniforms, transportation, computer equipment, software and internet access.
The earnings portion of a non-qualified distribution is taxed at the beneficiary’s rate plus a 10 percent tax penalty. Exceptions are made for the 10 percent tax penalty (but not the ordinary income taxes) for distributions made in connection with the beneficiary’s death or disability, because of the receipt of a scholarship, veterans education benefits or employer tuition assistance by the beneficiary, because of the attendance of the beneficiary at a U.S. military academy or because of coordination restrictions with the American Opportunity Tax Credit or Lifetime Learning Tax Credit.
Taxpayers cannot double dip. Taxpayers cannot use the same expenses to justify both the exclusion from income for distributions from a Coverdell education savings account and another education tax benefit, such as a tax-free distribution from a 529 college savings plan or the American Opportunity Tax Credit.
Contributions may be made to both a Coverdell education savings account and a 529 college savings or prepaid tuition plan for the same beneficiary in the same year.
Contributions may come from any individual, including the beneficiary, the beneficiary’s parents, grandparents, aunts, uncles or other relatives, and people unrelated to the beneficiary. Contributions may also come from corporations, trusts and other organizations.
Total combined contributions to a Coverdell education savings account are limited to $2,000 per beneficiary per year, regardless of the source of funds.
Excess contributions for the current and previous tax years are subject to a 6 percent excise tax. Excess contributions are reduced by the amount of any distributions. The excess contributions during the previous year may be offset by the difference between the current year’s contribution limit and the current year’s total contributions, if total contributions are less than the current year’s contribution limit. Note that the contribution limit is $2,000 or the sum of each contributor’s adjusted limit, whichever is less. Excess contributions do not include rollovers.
Five-year gift-tax averaging is available for contributions to a Coverdell education savings account, similar to the five-year gift tax averaging available for contributions to a 529 college savings plan or prepaid tuition plan account. However, five-year gift tax averaging is less likely to be necessary given that the $2,000 annual limit on contributions to a Coverdell education savings account is less than the annual gift tax exclusion.
Military death gratuities and payments from Servicemembers’ Group Life Insurance may be contributed to one or more Coverdell education savings accounts without regard to the annual contribution limits.
Contributions must end when the beneficiary reaches age 18. Distributions must occur within 30 days after the beneficiary reaches age 30 or dies. Both age limits are waived for special needs beneficiaries, such as disabled students.
Changing the Beneficiary
The beneficiary of a Coverdell education savings account may be changed to a member of the family of the current beneficiary, provided that the new beneficiary has not yet reached 30 years of age. Rollovers to the Coverdell education savings account of a member of the family of the current beneficiary are also permitted once per 12-month period, provided that the new beneficiary has not yet reached 30 years of age.
Members of the family of the beneficiary include the beneficiary’s spouse, the beneficiary’s son, daughter, stepchild, foster child, adopted child or their descendants, the beneficiary’s brother, sister, stepbrother or stepsister, the beneficiary’s father, mother or any ancestor of the beneficiary’s father or mother, the beneficiary’s stepfather or stepmother, the beneficiary’s nephews, nieces, aunts and uncles, the beneficiary’s son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law or sister-in-law, the spouse of any of these family members, and first cousins. In addition, a Coverdell education savings account may be transferred to the beneficiary’s ex-spouse, in the event of a divorce.
Coverdell education savings accounts are exempt from community property laws.
The exclusion from income for distributions from Coverdell education savings accounts is not subject to a phaseout on the tax-free treatment of the distributions.
There is, however, an income phaseout on contributions to Coverdell education savings accounts. The maximum contribution is reduced proportionately for taxpayers who file federal income tax returns with AGI between $95,000 and $110,000 (single) and between $190,000 and $220,000 (married filing jointly). Married taxpayers who file separate returns may not contribute to a Coverdell education savings account. There is no income limitation on contributions from corporations, trusts and other organizations. The income phaseouts are not adjusted annually for inflation.
A workaround for contributors whose income is above the income phaseouts involves giving the money to the child first. The child can then contribute the money to the child’s own Coverdell education savings account, assuming that the child’s income does not exceed the income phaseouts.
The legislation authorizing the exclusion from income for Coverdell education savings accounts does not expire.
- Coverdell Education Savings Account (ESA), Chapter 7, IRS Publication 970
- IRS Form 5329, Part V, Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts, Additional Tax on Excess Contributions to Coverdell ESAs
- IRS Form 1099-Q, Payments From Qualified Education Programs (Under Sections 529 and 530)
- Internal Revenue Code: 26 USC 530
- Regulations: None
- Taxpayer Relief Act of 1997, (P.L. 105-34, 8/5/1997), added Education Individual Retirement Accounts (IRA) effective starting with the 1998 tax year
- Internal Revenue Service Restructuring and Reform Act of 1998, (P.L. 105-206, 7/22/1998), adds requirement to distribute balances within 30 days of the beneficiary reaching age 30, adds coordination restrictions
- Consolidated Appropriations Act, 2001, (P.L. 106-554, 12/21/2000), minor change
- Economic Growth and Tax Relief Reconciliation Act of 2001, (P.L. 107-16, 6/7/2001), increases annual contribution limit from $500 to $2,000, increases income phaseouts to remove the marriage penalty, adds elementary and secondary school expenses to the definition of qualified education expenses, adds 529 college savings and prepaid tuition plans to the list of qualified education expenses, adds waiver to the age limitations for special needs children, adds coordination restrictions for Hope and Lifetime Learning tax credits and the 529 college savings and prepaid tuition plans, effective starting with the 2002 tax year
- Untitled legislation, (P.L. 107-22, 7/26/2001), renames the savings plan from Education Individual Retirement Account (Education IRA) to Coverdell Education Savings Account
- Job Creation and Worker Assistance Act of 2002, (P.L. 107-147, 3/9/2002), minor change
- Military Family Tax Relief Act of 2003, (P.L. 108-121, 11/11/2003), added exception to the 10% additional tax penalty for unqualified distributions for attendance at one of the military service academies
- Working Families Tax Relief Act of 2004, (P.L. 108-311, 10/4/2004), minor changes
- Gulf Opportunity Zone Act of 2005, (P.L. 109-135, 12/21/2005), modified definition of eligible educational institution
- Heroes Earnings Assistance and Relief Tax Act of 2008, (P.L. 110-245, 6/17/2008), adds language relating to military death gratuity
- American Taxpayer Relief Act of 2012, (P.L. 112-240, 1/2/2013), permanently eliminates the expiration of the 2001 changes by repealing Title IX of the Economic Growth and Tax Relief Reconciliation Act of 2001
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