Understanding Coverdell
Education Savings Accounts ("ESA")
Seeing a child work toward a college degree is a parent's dream.
But with rapidly escalating costs of higher education, this dream
can become a financial nightmare. A Coverdell Educational
Savings Account (ESA) can help parents sleep at night. The
main benefits of a Coverdell ESA include:
. Unlike state 529 plans, Coverdell ESAs can be used to pay for
qualified elementary and secondary education expenses.
. Earnings grow on a tax-deferred basis, and distributions are
tax-free if the money is used to pay qualified education expenses.
This information provides answers to your questions and can help
you decide whether or not a Coverdell ESA is a good choice for you
and your family.
GENERAL
 What
is an ESA?
For
whom may an ESA be established?
What
is a "special needs beneficiary"?
Where
may an individual open an ESA?
How
many ESAs may a Designated Beneficiary have?
CONTRIBUTION
When
may a taxpayer start contributing to an ESA?
How
much may be contributed to a Designated Beneficiary's ESA?
What
is the deadline for making ESA contributions?
What
happens if more than $2,000 is contributed to an ESA on behalf
of a Designated Beneficiary in a calendar year?
May
contributions other than cash be made to a Designated Beneficiary's
ESA?
May
contributors take a deduction for contributions made to an
ESA?
Are
there any restrictions on who can contribute to an ESA?
Do
contributors have to have compensation or earned income to
make contributions to an ESA?
May
a Designated Beneficiary contribute to his or her own ESA?
Does
a taxpayer have to be related to the Designated Beneficiary
in order to contribute to the Designated Beneficiary's ESA?
May
contributions be made to both a qualified tuition program (QTP)
and an ESA
on behalf of the same Designated Beneficiary in
the same taxable year?
DISTRIBUTIONS
May
a Designated Beneficiary take a tax-free withdrawal from an
ESA to pay qualified
education expenses if the Designated Beneficiary
is enrolled less than full-time at
an eligible educational
institution?
What
happens when a Designated Beneficiary withdraws assets from
an ESA to pay for qualified education expenses?
What
is an eligible educational institution?
What
are "qualified education expenses" for elementary
and secondary schools?
What
are "qualified education expenses" for post-secondary
schools?
What
is a "half time" student?
What
happens if a Designated Beneficiary withdraws an amount from
an ESA but does not
have any qualified education expenses to
pay in the taxable year he or she makes the withdrawal?
Is
the distribution from an ESA taxable if the distribution is
contributed to another ESA?
What
happens to the assets remaining in an ESA after the Designated
Beneficiary finishes his or her postsecondary education?
Rather
than rolling or transferring the money from one ESA to another,
may the Designated
Beneficiary of the account be changed from
one Designated Beneficiary to another without triggering a
tax?
May
the Designated Beneficiary or the Designated Beneficiary's
parents claim the Hope
Scholarship Credit or Lifetime Learning
Credit for the Designated Beneficiary's expenses in a
taxable
year in which the Designated Beneficiary receives money from
an ESA on a tax-free basis?
What if the Designated Beneficiary earns an academic scholarship and the tuition is waived?
When
must assets in an ESA be distributed?
Can
the ESA be transferred to another individual?
Do
any exceptions apply to the distribution requirement when the
Designated Beneficiary dies?
ADDITIONAL
PROVISIONS
Transfers
Prohibited
Transactions
Using
the ESA as Security for a Loan
MISCELLANEOUS
Non-forfeitability
Investment
Restrictions
No
Commingling
Tax
Filing
IRS
Form
GENERAL
What
is an ESA?
An ESA is a trust or
custodial account that is created or organized in the United
States exclusively for the purpose of paying the qualified
education expenses of the Designated Beneficiary of the
account. The account must be designated as an ESA when
it is created to be treated as an ESA for tax purposes.
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For
whom may an ESA be established?
An ESA may be established for
the benefit of any child under age 18. Contributions to the
ESA will not be accepted after the Designated Beneficiary
reaches his or her 18th birthday, unless he or she is a "special
needs" Designated Beneficiary.
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What
is a "special needs beneficiary"?
The IRS has not yet defined
a special needs beneficiary. This Coverdell ESA will incorporate
the definition by reference, once made available.
However, a general definition
may include individuals who require additional time to complete
their education due to a physical, mental or emotional condition.
Taxpayers who believe the special needs beneficiary rules apply
to their situation should consult a competent tax advisor for
guidance.
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Where
may an individual open an ESA?
An individual may open an ESA
with any bank, or other entity that has been approved to
serve as a non-bank trustee or custodian of an individual
retirement account (IRA), and the bank or entity is offering
ESAs.
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How
many ESAs may a Designated Beneficiary have?
There is no limit on the number
of ESAs that may be established designating a particular
individual as a Designated Beneficiary. However, in any given
taxable year, the total contributions to all the
ESAs for one individual as beneficiary may
not exceed $2,000.
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CONTRIBUTIONS
When
may a taxpayer start contributing to an ESA?
Contributions were first permitted
to ESAs on January 1, 1998. Contributions may be made to
a Designated Beneficiary's ESA from birth until his or her
18th birthday (unless the Designated Beneficiary is a special
needs beneficiary).
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How
much may be contributed to a Designated Beneficiary's ESA?
Up to $2,000
per year in aggregate contributions may be made for the benefit
of any Designated Beneficiary. The contributions may be placed
in a single ESA or in multiple ESAs.
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What
is the deadline for making ESA contributions?
Contributions must be made
by the contributor's tax return due date excluding extensions.
For most taxpayers, the deadline is April 15th.
Contributions made between January
1 and April 15 should include an indication of the tax year
the contribution is for. If the tax year is not indicated otherwise,
the ESA Trustee or Custodian will report it to the IRS as a
current year contribution (the year received).
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What
happens if more than $2,000 is contributed to an ESA on
behalf of a Designated Beneficiary in a calendar year?
Aggregate contributions for
the benefit of a particular Designated Beneficiary in excess
of $2,000 for a calendar year are treated as excess contributions.
If the excess contributions (and any earnings attributable
to them) are not withdrawn from the Designated Beneficiary's
account (or accounts) before June 1 of the year following
the year for which the contribution was made, the excess
contributions are subject to a 6 percent excise tax for each
year the excess amount remains in the account.
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May
contributions other than cash be made to a Designated Beneficiary's
ESA?
No. ESAs are permitted to accept
contributions made in cash only.
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May
contributors take a deduction for contributions made to
an ESA?
No.
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Are
there any restrictions on who can contribute to an ESA?
Individuals with a
modified adjusted gross income (MAGI) of up to$95,000
($190,000 for married taxpayers filing jointly) may contribute the full amount of $2,000. For most taxpayers, MAGI is
the same as adjusted gross income. For those taxpayers
who earn income abroad or receive income from certain American
territories or possessions, MAGI will be greater than the
adjusted gross income. In those cases, the individual's adjusted
gross income will be increased by: (1) certain amounts that
the individual earns abroad, (2) amounts effectively connected
with the individual's conduct of a trade or business derived
from sources in Guam, American Samoa, or the Northern Mariana
Islands (if the individual is a resident of the possession
where the source of income is located), and (3) amounts derived
from sources in Puerto Rico (if the individual is a Puerto
Rican resident).
The $2,000 maximum contribution
is gradually reduced for individuals
with MAGI between $95,000 and $110,000 (between $190,000 and
$220,000 for married taxpayers filing jointly). For example,
an unmarried taxpayer with MAGI of $96,500 in a taxable year
could make a maximum contribution per Designated Beneficiary
of $450 for that year.
Taxpayers with MAGI above the $110,000
($220,000 for married taxpayers filing jointly) cannot make
contributions to anyone's ESA.
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Do
contributors have to have compensation or earned income
to make contributions to an ESA?
No.
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May
a Designated Beneficiary contribute to his or her own ESA?
Yes.
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Does
a taxpayer have to be related to the Designated Beneficiary
in order to contribute to the Designated Beneficiary's
ESA?
No.
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May
contributions be made to both a qualified tuition program
(QTP) and an ESA on behalf of the same Designated Beneficiary
in the same taxable year?
Yes.
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DISTRIBUTIONS
May
a Designated Beneficiary take a tax-free withdrawal from
an ESA to pay qualified education expenses if the Designated
Beneficiary is enrolled less than full-time at an eligible
educational institution?
Yes. Whether the Designated
Beneficiary is enrolled full-time, half-time, or less than
half-time, he or she may take a tax-free withdrawal to pay
qualified education expenses.
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What
happens when a Designated Beneficiary withdraws assets
from an ESA to pay for qualified education expenses?
Generally, the withdrawal is
tax-free to the Designated Beneficiary to the extent the
amount of the withdrawal does not exceed the Designated Beneficiary's
qualified education expenses at an eligible educational institution.
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What
is an eligible educational institution?
An eligible post-secondary
educational institution is any college, university, vocational
school, or other postsecondary educational institution that
is described in section 481 of the Higher Education Act of
1965 (20 U.S.C. 1088) and, therefore, eligible to participate
in the student aid programs administered by the Department
of Education. This category includes virtually all accredited
public, nonprofit, and proprietary (privately owned profit-making)
postsecondary institutions. An eligible elementary or secondary
school is any public, private, or religious school that provides
kindergarten through grade 12 education as determined under
state law.
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What
are "qualified education expenses" for elementary
and secondary schools?
Expenses are qualified that
are related to enrollment or attendance such as tuition,
books, supplies, equipment, academic tutoring, and special
needs services for a special needs beneficiary. In addition,
expenses also qualify that are provided by an eligible school
in connection with attendance or enrollment such as room
and board, uniforms, transportation, supplementary items
and services (including extended day programs). Expenses
related to the purchase of computer technology, equipment
or Internet access qualify if the items are used by the Designated
Beneficiary and his or her family during any of the years
the Designated Beneficiary is in school. (This does not include
expenses for computer software designed for sports, games
or hobbies unless the software is predominantly educational
in nature.)
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What are "qualified education expenses" for post-secondary
schools?
Expenses are qualified that
are related to enrollment or attendance such as tuition and
fees, books, supplies, equipment, and special needs services
for a special needs beneficiary. In addition, expenses for
room and board qualify provided the Designated Beneficiary
is at least a half-time student. However, only room and board
expenses qualify that do not exceed the greater of
(1) the
allowance for room and board, as determined by the eligible
educational institution, that was included in the cost of
attendance (for federal financial aid purposes) for a particular
academic period and living arrangement of the student and
(2) the actual amount charged if the student is residing
in housing owned or operated by the eligible educational
institution.
Any contribution to a qualified tuition program
(QTP) made on behalf of the Designated Beneficiary also is
a qualified education expense.
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What
is a "half-time" student?
A Designated Beneficiary is
a student enrolled "at least half-time" if he or
she is enrolled for at least half the full-time academic
work load for the course of study the student is pursuing,
as determined under the standards of the school where the
student is enrolled.
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What
happens if a Designated Beneficiary withdraws an amount
from an ESA but does not have any qualified education expenses
to pay in the taxable year he or she makes the withdrawal?
Generally, if a Designated
Beneficiary withdraws an amount from an ESA and does not
have any qualified education expenses during the taxable
year, a portion of the distribution is taxable. The portion
subject to income taxes is the portion that represents earnings
that have accumulated tax-free in the account. The taxable
portion of the distribution is also subject to a 10 percent
tax penalty as well unless:
a. The withdrawal is paid
to the estate of the Designated Beneficiary within 30 days
of his or her death;
b. The withdrawal is paid to
the Designated Beneficiary due to his or her disability;
or
c. The withdrawal is equal
to or less than the amount of a scholarship or other tax-free
educational assistance received by the Designated Beneficiary.
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Is
the distribution from an ESA taxable if the distribution
is contributed to another ESA?
Any amount distributed from
an ESA and rolled over or transferred to another ESA for
the benefit of the same Designated Beneficiary or certain
members of the Designated Beneficiary's family is not taxable.
An amount is rolled over if it is paid to another ESA on
a date within 60 days after the date of the distribution.
Members of the Designated Beneficiary's family include the
Designated Beneficiary's spouse, children and their descendants,
stepchildren and their descendants, siblings and their children,
stepbrothers and stepsisters, parents and grandparents, stepparents,
and spouses of all the foregoing. In addition, family members
include first cousins, father-in-law, and mother-in-law.
The $2,000 annual contribution limit to ESAs does not apply
to these rollover contributions. For example, an older brother
who has $2,000 left in his ESA after he graduates from college
can roll over the full $2,000 balance to an ESA for his younger
sister who is still in high school without paying any tax
on the transfer.
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What
happens to the assets remaining in an ESA after the Designated
Beneficiary finishes his or her postsecondary education?
There are two options. The
amount remaining in the account may be withdrawn for the
Designated Beneficiary. The Designated Beneficiary will be
subject to both income tax and the additional 10 percent
penalty tax on the portion of the amount withdrawn that represents
earnings if the Designated Beneficiary does not have any
qualified education expenses in the same taxable year he
or she makes the withdrawal. Alternatively, if the amount
in the designated beneficiary's ESA is withdrawn and rolled
over or transferred to another ESA for the benefit of a member
of the Designated Beneficiary's family, the amount
rolled over or transferred will not be taxable.
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Rather
than rolling or transferring the money from one ESA to
another, may the Designated Beneficiary of the account
be changed from one Designated Beneficiary to another without
triggering a tax?
Yes, provided: (1) the terms
of the particular trust or custodial account permit a change
in the Designated Beneficiaries (each trustee or custodian
will control whether options like this one are available
in the accounts they offer), and (2) the new Designated Beneficiary
is a member of the previous Designated Beneficiary's family
and has not attained age 30.
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May
the Designated Beneficiary or the Designated Beneficiary's
parents claim the Hope Scholarship Credit or Lifetime Learning
Credit for the Designated Beneficiary's expenses in a taxable
year in which the Designated Beneficiary receives money
from an ESA on a tax-free basis?
Yes, an education credit may
be claimed in the same year the Designated Beneficiary takes
a tax-free distribution from his or her ESA as long as the
same expenses are not used for both benefits. Refer to IRS
Publication 970 and/or your tax advisor for more guidance.
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What if the Designated Beneficiary earns an academic scholarship and the tuition is waived?
The amount of scholarship money the Designated Beneficiary receives is deducted from the allowable expenses for the Coverdell ESA.
For example, if qualified expenses total $6,000 and the Designated Beneficiary receives a scholarship for $3,000, the Designated Beneficiary can make a qualified withdrawal of $3,000 from the Coverdell ESA.
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When
must assets in an ESA be distributed?
ESA assets must be distributed
no later than 30 days after the Designated Beneficiary's
death or attainment of age 30. (This rule does not apply
to special needs beneficiaries.)
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Can
the ESA be transferred to another individual?
Yes. If the designated beneficiary) decides not to go to college or leaves school before all the funds are withdrawn, you can roll unused funds into the Coverdell ESA of another family member. The beneficiary of the Coverdell ESA who receives the unused funds must be under the age of 30 (except that the age 30 limit does not apply to a special needs beneficiary).
Family members of the designated beneficiary who are eligible to receive unused funds include (but are not limited to) spouses, siblings, stepsiblings, nieces, nephews, first cousins, parents, aunts, uncles, grandparents, children and grandchildren.
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Do
any exceptions apply to the distribution requirement when
the Designated Beneficiary dies?
Yes. If the Responsible Individual
rolls over or transfers the ESA to a surviving spouse or
other eligible family member due to the Designated Beneficiary's
death, the ESA retains its status. This means the spouse
or other family member may treat the ESA as his or her own
until he or she attains age 30. The age limitation does not
apply to new Designated Beneficiaries who are special needs
beneficiaries. There are no tax consequences due to the transfer. If
the ESA agreement allows the designation of a Death Beneficiary
and that Death Beneficiary is not an eligible family member,
the remaining assets must be distributed within 30 days of
the Designated Beneficiary's date of death. ESA assets distributed
(that are not rolled over or transferred to another eligible
family member) are taxable to the extent they represent earnings
distributed from the account.
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ADDITIONAL PROVISIONS
Transfers. ESAs
may be moved from one trustee or custodian to an IRA maintained
by another trustee or custodian by requesting a direct transfer.
Federal law does not limit
the number of transfers you may make during any year. ESA
transfers are reportable to the IRS.
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Prohibited
Transactions. The
ESA may not be engaged in a "prohibited transaction." Prohibited
transactions are defined in IRC Section 4975.
Examples include borrowing
money from the ESA, selling property to the ESA, receiving
unreasonable compensation for managing the ESA or buying
property with ESA funds for your personal use. Engaging in
a prohibited transaction will most likely result in adverse
tax consequences, including disqualification of the ESA.
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Using the ESA as Security for a Loan. If
the ESA is pledged as security for a loan, the amount pledged
is treated as a distribution and is includable in income
and may be subject to the 10 percent premature distribution
penalty tax.
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MISCELLANEOUS
Non-forfeitability. Your
interest in your ESA is non-forfeitable at all times.
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Investment
Restrictions. Money
in the ESA may not be used to buy a life insurance policy
or invested in collectibles as defined in IRC Section 408(m). However,
certain gold, silver and platinum coins, bullion and coins
issued under state laws are allowable investments.
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No
Commingling. Assets
in the ESA may not be combined with other property, except
in a common trust fund or common investment fund.
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Tax
Filing. The
Responsible Individual is responsible for filing the applicable
IRS forms to report certain activities, taxable income
and/or penalties associated with the ESA.
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IRS
Form. This
ESA uses the precise language of IRS Form 5305-E or 5305-EA
and is therefore treated as approved by the IRS. Additional
language has been included as permitted by such form. The
IRS approval represents a determination as to form and
not to the merits of the account.
IRS
FORMS PAGE
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