Who Can Open a Coverdell ESA?

Anyone can open a Coverdell ESA for a designated beneficiary under the age of 18 when the account is opened.  The account can be opened in the United States at any bank or entity approved by the Internal Revenue Service (IRS) to offer Education Savings Accounts.  Any person can contribute to the ESA, provided their modified adjusted gross income is less than $110,000 ($220,000 if married filing jointly).  More than one Coverdell ESA can be established for the same beneficiary, but the total combined contributions to all ESAs for that beneficiary cannot be more than $2,000 in any given year.

Requirements for Opening a Coverdell ESA

When the account is set up, it must be designated as a Coverdell Education Savings Account, and it must satisfy the following requirements:

• The trustee or custodian of the account must be a bank or an entity approved by the IRS for opening Coverdell ESAs.
• The document that creates and governs the account must be in writing, and must specify that:
•  contributions can only be accepted in cash,
• contributions must be made before the beneficiary reaches age 18,
• total contributions for the designated beneficiary cannot be more than $2,000 in any one year,
• 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 or investment fund,
• the balance in the account must be distributed within 30 days after the earlier of:
• the date the beneficiary reaches age 30, or
• the date of the beneficiary’s death.

What Education Expenses Qualify?

Primary and Secondary Education

Some primary and secondary education expenses must be required and provided by the school in order for distributions from a Coverdell ESA to qualify as nontaxable.

• Expenses that must be incurred in connection with enrollment or attendance include tuition, fees, books, supplies, equipment, and academic tutoring.
• Expenses that must be required or provided by the school include room and board, uniforms, transportation, and supplementary items and services.
• The purchase of computer equipment, software, and Internet access is a qualified education expense if it is used by the beneficiary and his or her family during any of the beneficiary’s elementary or secondary school years.  Software designed for sports, games, or hobbies does not qualify unless it is predominantly for educational purposes.

Higher Education

Some higher education expenses must be required by the institution, and some must be for a student who is enrolled at least half-time, in order for distributions from a Coverdell ESA to be nontaxable.

• Expenses that must be required for enrollment or attendance include tuition, fees, books, supplies, and equipment.
• Expenses for room and board must be for students who are enrolled at least half-time.  This means carrying at least half the full-time academic work load for the student’s course of study, as determined by the educational institution.
• The amount of room and board expense is limited to the greater of the allowance for room and board included in the cost of attendance (as determined for financial aid purposes, for example), or the actual amount the student is charged for residing in housing owned and operated by the educational institution.
• A contribution to a Qualified Tuition Program (529 plans) is also considered a qualified education expense, provided it is for the designated beneficiary of the Coverdell ESA.

Eligible Educational Institution

For Coverdell ESA purposes, eligible educational institutions include elementary and secondary schools, as well as colleges, universities, vocational schools, and any other institution that is eligible to participate in a student aid program administered by the U.S. Department of Education.

Eligible elementary and secondary schools include any public, private or religious school, for grades kindergarten through 12th grade.

Contributions to a Coverdell ESA

Amy individual can make contributions to a Coverdell ESA, including the beneficiary for whom the account was set up, provided their modified adjusted gross income for the year is less than $110,000 ($220,000 if married filing jointly).  Organizations can also make contributions to a Coverdell ESA and there is no limit on the organization’s level of income.

Rules and Limits

Contributions to a Coverdell ESA are not deductible, but earnings can grow tax-free in the account.  Contributions must be made in cash (not property), and there is a $2,000 limit per beneficiary per year.  If more than one person (or organization) contributes to the same ESA, the limit is $2,000 per year.  Also, if more than one Coverdell ESA has been opened for the same beneficiary, the total of all contributions to all ESAs set up for that person is limited to $2,000 per year.  Once the beneficiary reaches age 18, no more contributions can be made to a Coverdell ESA set up for that beneficiary.

Reduced Contribution Limit

Even though any individual whose modified adjusted gross income is less than $110,000 ($220,000 if married filing jointly) can contribute to a Coverdell ESA, the maximum amount that an individual can contribute is gradually reduced if that person’s modified adjusted gross income is between $95,000 and $110,000 ($190,000 and $220,000).

Example

The decrease in the amount that can be contributed is proportional to the amount by which modified adjusted gross income exceeds $95,000 ($190,000).  For example if your modified adjusted gross income is $98,000, the excess is $3,000 ($98,000 - $95,000).  To determine the amount by which the contribution limit is reduced, you would take $3,000 (the excess) divided by $15,000 (the maximum of $110,000 minus $95,000, the lower limit for reduced contributions) = 0.2.  You would then take 0.2 times $2,000 (the maximum contribution) = $400.  The maximum contribution you could make would therefore be $1,600 ($2,000 minus $400).  This would leave $400 that could be contributed by someone else for that year for that beneficiary.

Additional Tax on Excess Contributions

Any excess contributions that remain in the Coverdell ESA at the end of the year are subject to a 6% excise tax, that must be paid by the beneficiary.  Excess contributions are defined as the total of:

1. Contributions to a beneficiary’s Coverdell ESA in excess of $2,000 for the year, or if the individual contributor’s limits are less, as described above, the excess over the total of their individual contribution limits.  (But in any case, the total of different person’s individual contributions cannot be more than $2,000 for the year.)
2. Excess contributions from the previous year, less the total of:
1. distributions from the account during the year, and
2. any amount that could have been contributed this year, but was not.

The 6% excise tax does not apply on excess contributions made during the current year if the excess, and any earnings on the excess, is distributed by June 1 of the following year (or the first day of the sixth month of the following year, if taxes are reported on a fiscal year basis).  But in this case, the portion of the distribution that represents earnings would have to be included in the taxable income of the person who made the excess contributions, in the year they were made.  If excess contributions were distributed, you should receive Form 1099-Q, Payments from Qualified Education Programs (Under Sections 529 and 530), from the institution that distributed the excess contributions.  These earnings would be reported as “Other Income” on Form 1040.

Example

• If contributions of $2,400 were made to a beneficiary’s Coverdell ESA in year 1, and the excess of $400 was not distributed by June 1 of year 2, the beneficiary would owe a tax of $24 for year 1 ($400 times 6%).
• If contributions of $2,500 were made in year 2, but the beneficiary withdrew $300 to pay qualified education expenses, the excess at the end of year 2 would be:
• $400 excess from year 1
•  plus $500 excess from year 2
• minus $300 withdrawal in year 2
• equals $600 excess contribution at the end of year 2.  An excise tax of $36 would be owed for year 2 ($600 times 6%).
• If contributions in year 3 are limited to $1,400 ($2,000 minus $600 excess balance) no excise tax will be owed at the end of year 3.

If the excise tax is owed, it is calculated and reported in Part V of Form 5329, Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts.

Rollovers and Transfers

Distributions from a Coverdell ESA can be rolled over to another Coverdell ESA, either for the same beneficiary or for a member of the beneficiary’s family (including the beneficiary’s spouse) under 30 years of age.  If the rollover is done within 60 days, the distribution will not be taxable.

Instead of taking a distribution and rolling it over to another Coverdell ESA, the designated beneficiary can transfer the balance to a family member by instructing the trustee to change the name of the designated beneficiary on the account.  This does not generate any tax consequences, provided the new beneficiary is under age 30.

Distributions

The designated beneficiary of a Coverdell ESA can withdraw funds at any time.  Whether the distribution is taxable will depend on whether the distributions during a year are equal to or less than the amount of qualified education expenses the beneficiary has during the year, reduced by any tax-free educational assistance, including:

• the tax-free part of scholarships or fellowships,
• veterans’ educational assistance,
• Pell grants,
• employer-provided educational assistance.

The amount determined by subtracting any tax-free educational assistance from qualified education expenses is referred to as “adjusted qualified education expenses”.

Tax-Free Distributions

If the amount withdrawn from a Coverdell ESA (the distribution) is less than adjusted qualified education expenses, the distribution is tax-free.

Taxable Distributions

If the amount withdrawn from a Coverdell ESA is more than adjusted qualified education expenses, the excess portion of the distribution is partially taxable. The part that is taxable is the portion of the distribution that represents earnings that have accumulated tax-free in the account.

Part of the distribution represents a return of your basis – contributions that have been made to the Coverdell ESA.  Since these contributions were not deductible when made, they are not taxed when distributed.  Assuming you paid adjusted qualified education expenses with the amount you withdraw, part of the accumulated earnings would also be tax-free:

• tax-free earnings equals
• amount of the distribution
• minus the part that represents a recovery of your basis
• equals the portion of the distribution that represents accumulated earnings.
• The above amount (earnings)
• times the proportion of your adjusted qualified education expenses / your distribution
• equals tax-free earnings.

It then follows that total earnings minus tax-free earnings equals taxable earnings.  This taxable part would be reported as Other Income on Form 1040.

There is a worksheet entitled “Coverdell ESA – Taxable Distribution and Basis” in IRS Publication 970, Tax Benefits for Education, that will take you through the exercise described above.

Coordinating with Other Education Benefits

Hope and Lifetime Learning Credits

You may be able to take the Hope or lifetime learning credit in the same year the beneficiary takes a tax-free distribution from a Coverdell ESA, provided the benefits are not determined on the same education expenses.

In this case, you would have to reduce your adjusted qualified education expenses by the amount taken into consideration in figuring the Hope or lifetime learning credit:

• Total qualified education expenses
• Minus tax-free educational assistance
• Minus expenses taken into account in figuring the Hope or lifetime learning credit
• Equals adjusted qualified education expenses

Once that calculation is done, you can take your adjusted qualified education expenses, and the amount of the distribution you received, and calculate the taxable portion of the earnings in that distribution using the calculation indicated above.

Qualified Tuition Program Disbursements

If distributions are received from both a Coverdell ESA and a Qualified Tuition Program (529 plan)  the same year, and the total amount received is more than adjusted qualified education expenses, the expenses must be allocated to the distributions to determine how much of each is taxable.  You can allocate your expenses in any reasonable manner.

For example, the year in which a beneficiary graduates from high school and enters college, a vocational school, or other postsecondary school, and has qualified education expenses for both, the Coverdell distribution may be allocated in part or in total to cover any high school expenses, since these are qualified expenses for purposes of the Coverdell ESA but not for the Qualified Tuition Program.  The remainder of the distributions could then be allocated to postsecondary education expenses, which may qualify under both plans.

Additional Tax

If part of a distribution is taxable, in addition to the normal federal income tax that applies, you must also pay a 10% additional tax on the amount you had to include in income.  But there are exceptions.  The additional 10% tax does not apply on:

• Distributions paid after the designated beneficiary’s death,
• Distributions made because the beneficiary is disabled,
• Amounts that had to be included in income because the beneficiary received tax-free educational assistance,
• Distributions made when the designated beneficiary attends a U.S. military academy,
• Amounts included in income when coordinating with the Hope or lifetime learning credit,
• Distributions made by June 1 of the following year, of excess contributions from the previous year.

If none of the exceptions apply, and you owe the additional 10% tax, you would calculate and report it in Part II of Form 5329.

When the Balance in the Account Must Be Distributed

Any balance remaining in a Coverdell ESA must be distributed within 30 days after:

• The designated beneficiary reaches age 30, or
• The designated beneficiary dies before reaching age 30.

In the event of the designated beneficiary’s death, the Coverdell ESA can be transferred to the surviving spouse or other family member of the beneficiary who is under age 30.

Taxable Earnings from a Total Distribution

A total distribution made when the designated beneficiary reaches age 30 or dies, is subject to tax on the accumulated earnings in the account.  This is the difference between the balance in the account and the basis in the account (total amounts contributed).

The person receiving the distribution would report the earnings as Other Income on Form 1040.