Coverdell Educational Savings Accounts

A Coverdell education savings account (ESA) is a trust or custodial account set up expressly to pay the qualified educational expenses of a designated beneficiary. Sometimes called an Education IRA, the earnings grow tax-free and the portion of earnings distributed and used to pay qualified educational expenses is also tax-free. However, unlike a traditional IRA, the contributions are not tax-deductible. Moreover, all contributions must be made in cash and deposited before the beneficiary reaches 18 unless the beneficiary has special needs, in which case, there is no age limit.

Nowadays, most people use 529 plans instead of Coverdell accounts, because Coverdell accounts have several disadvantages, including:

• annual contributions limited to $2000,
• contributions cannot be continued after the beneficiary reaches 18 years of age, and
• a donor’s high income may be restrict or prevent contributions.

However, Coverdell ESAs can supplement 529 plans.

Coverdell ESA Contributions

The contribution deadline for any given year is by the due date of the return for that year, not including extensions. A contribution made before the due date of the tax return can be allocated to the previous year, in which case, the contribution is deemed to have been made on December 31 of the previous year.

Contributions must be cash. The contribution limit for any designated beneficiary is $2000, not including rollovers, even if the contributions were made by different individuals. So if a mother contributes $1500 to a Coverdell ESA for her child and a grandfather of the child also wants to make a contribution in a separate Coverdell ESA that he has set up, he will be limited to a $500 contribution for that year. However, contributions can be made to both a Coverdell ESA and a Qualified Tuition Program in the same year for the same beneficiary. Furthermore, contributions are deemed a gift, so the amount contributed must be added to any other gifts to the same beneficiary by the same taxpayer to determine if the amount is within the annual gift-tax exclusion; otherwise, a gift tax may apply.

There are phaseout limits that apply to upper income taxpayers, based on the taxpayer's modified adjust gross income (MAGI), = adjusted gross income (AGI) + any foreign earned income exclusion + any foreign housing exclusion or deduction + any excluded income earned by residents of Puerto Rico or American Samoa. For most taxpayers, MAGI = AGI.

More than 1 Coverdell ESA can be set up for an individual but the total contribution cannot exceed $2000, no matter how many people contribute to it; otherwise, a 6% excise tax will be applied to any excess amount over $2000 for any individual beneficiary for each year that there is an excess. The excess can be reduced by a distribution to pay for qualified educational expenses, or by contributing less than the $2000 maximum in succeeding tax years. The penalty can be avoided altogether if the excess contributions and any associated earnings are withdrawn before June 1 of the following year. The withdrawn earnings are taxable to the taxpayer who made the excess contribution. The penalty is imposed on the beneficiary and is calculated on Form 5329, Additional Taxes on Qualified Plans (Including IRAs) and other Tax Favored Accounts.

Tax Tip: Unlike traditional IRAs, a contributor to a Coverdell account does not have to have earned income nor is there any age limit. Therefore, 1 way around the MAGI limitation is to gift the contribution to the child so that she can make the contribution herself.

Distributions from Coverdell ESA's

Distributions from a Coverdell ESA are not taxed if used to pay qualified educational expenses, even for designated beneficiaries who are only part-time students, since there is no minimum number of courses needed to be taken for the distribution to be tax-free. If the distribution exceeds such expenses, then the earnings that are allocable to the excess amount is taxable to the beneficiary.

Qualified educational expenses are for elementary and secondary educational institutions, kindergarten through grade 12, and postsecondary educational institutions, such as colleges or universities, that participate in the student aid programs administered by the US Department of Education. The institution can be public, private, or religious. Qualifying expenses, if they are incurred because of enrollment or attendance at the institution, include:

• tuition and fees,
• books, supplies, and equipment,
• academic tutoring, and
• services provided for a beneficiary with special needs.

However, the following expenses are qualified only if they are required by the educational institution:

• room and board,
• uniforms,
• transportation, and
• other supplementary items and services, including extended day programs.

The following expenses are also qualified if used by either the beneficiary or her family during enrollment at a qualified elementary or secondary school:

• computers and peripheral equipment,
• Internet access, and
• software, as long as it has an educational benefit.

A Coverdell ESA distribution can be used along with the American Opportunity Credit or the Lifetime Learning Credit, but they may not be used to cover the same expenses. To calculate the tax-free part of any distribution, the qualified educational expenses must be reduced by any tax-free educational assistance, Pell grants, veterans' educational systems, employer-provided educational assistance, American Opportunity Credit, or Lifetime Learning Credit, or any other tax-free educational assistance payments, other than gifts or inheritance, which yields the adjusted qualified educational expenses (AQEE). Note that although the maximum American Opportunity Credit is only $2500, it applies to $4000 of expenses, so that is what must be subtracted in calculating the qualified higher educational expenses. If the adjusted qualified educational expenses exceed the distribution, then the entire distribution is tax-free, otherwise the taxable portion is somewhat complicated, but based on the following principles:

• Each Coverdell ESA distribution consists of 2 components: contributions and earnings.
• Because contributions are made with after-tax dollars, the total undistributed contributions form the tax basis of the account, so that part of the distribution that is allocated to basis is never taxed, even if the money is not used to pay qualified educational expenses.
• The remaining part of the distribution is earnings. That part of the earnings that is used to pay qualified educational expenses is tax-free; the remaining amount is taxable to the designated beneficiary.
• So the basic steps needed to find the taxable portion of any distribution is to 1st determine the allocation between the tax basis and earnings, and then to determine the allocation between tax-free and taxable earnings.

The taxable portion of a distribution is computed as follows:

Coverdell ESA Basis = Total Contributions before the Current Year That Have Not Been Distributed + Total Contributions for Current Tax Year

• Note that the Coverdell ESA basis for the next year will be decreased by the allocable bases of all distributions in the current year.
• This portion of the distribution is nontaxable because it is considered a return of capital. Since contributions are made with after-tax income, it is not taxed again when it is distributed.

Taxable Portion of Distribution (Allocated Earnings) = Total Distribution − Allocated Basis

• Note that if Adjusted Qualified Education Expenses = Total Distribution, then the above fraction = 1, so Tax-Free Allocated Earnings = Allocated Earnings

Taxable Allocated Earnings = Allocated Earnings − Tax-Free Allocated Earnings

The taxpayer will not usually have to calculate taxable income, since that will be shown on Form 1099-Q, Payments from Qualified Education Programs (under §§529 and 530) that is sent by the account custodian, but the above example shows how it is calculated. Taxable earnings is reported as Other Income in the Income section of Form 1040.

There is a 10% additional tax on any taxable distributions that must be included in income unless:

• the distributions were made to a beneficiary or the estate of the designated beneficiary, or the distribution was made because the designated beneficiary is disabled;
• the designated beneficiary received a tax-free scholarship or educational assistance allowance that equals or exceeds the distribution; or
• the distribution was taxable only because the qualified ESA educational expenses were reduced by expenses in which the American Opportunity or Lifetime Learning Credit was applied.

However, the 10% additional tax is not assessed on the withdrawal of excess contributions or on the allocable basis of the distribution.

Any balance in a Coverdell ESA must be withdrawn within 30 days after the designated beneficiary reaches age 30, unless the beneficiary has special needs. However, the account can be extended by changing the designated beneficiary or rolling over the account to another member of the beneficiary's family who is younger than 30. The rollover from a Coverdell ESA to another account of the designated beneficiary's family must be made within 60 days for it to be tax-free. Only one rollover per Coverdell ESA is permitted during the year ending on the date of the payment or withdrawal.

If the designated beneficiary dies before age 30, then the account balance must be distributed to the beneficiary's estate within 30 days of the date of death unless it is transferred to a surviving spouse or other family member younger than 30, in which case, it can be maintained until the new beneficiary reaches 30, unless the beneficiary has special needs, in which case, it can be continued indefinitely. In the year in which a distribution is made because of age or death, the earnings from the distribution must be included as taxable income to the person receiving the distribution. The tax is calculated thus:

Taxable Earnings = Final Distribution − Allocated Basis of Final Distribution

Eligible members of the beneficiary's family include:

• children, stepchildren, foster children, adopted children, or any descendants thereof;
• siblings or step-siblings;
• any ancestors of the beneficiary;
• step-father or -mother;
• nephews, nieces, uncles, and aunts;
• children-in-law, parents-in-law, siblings-in-law;
• spouses of any of the above;
• first cousins.

If a designated beneficiary also receives a distribution from a Qualified Tuition Program (QTP), and both distributions are used to pay the qualified educational expenses at a particular educational institution, then the total qualified expenses are allocated thus:

Allocation of Qualified Expenses to ESA Distribution = Total Qualified Expenses × ESA Distribution/Total Distribution.

Allocation of Qualified Expenses to QTP Distribution = Total Qualified Expenses × QTP Distribution/Total Distribution

The taxable portion of each distribution must then be calculated according to the allocation.

Notes

• A transfer of a Coverdell ESA to a spouse or former spouse because of a divorce or separation agreement is not taxable.
• A military death gratuity or a payment from the Service members' Group Life Insurance (SGLI) may be rolled over to one or more Coverdell ESA's for eligible members of the deceased service member's family.

Historical Notes

• Previous to the 2017 Tax Cuts and Jobs Act (TCJA), losses on a Coverdell ESA were deductible as a miscellaneous itemized deduction figured on Schedule A, Itemized Deductions, subject to the 2% adjusted gross income floor, but the TCJA eliminated this deduction. Losses were only deductible, however, when the total amount in the Coverdell ESA had been distributed and the total of the distributions was less than the tax basis of the account, which occurred when losses exceeded gains. However, a loss in 1 ESA account can be used to reduce gains from other ESA accounts.