Coverdell Education Savings Account (ESA)

"Coverdell Education Savings Account (ESA) " submitted by SchoolGrantsfor Editorial Team and last updated on Monday 9th January 2012

A Coverdell Education Savings Account (also known as an Education Savings Account, a Coverdell ESA, a Coverdell Account, or just an ESA and formerly known as an Education Individual Retirement Account), is a tax-advantaged investment account in the United States designed as an incentive to help parents and students save for education expenses to encourage savings to cover future education expenses (elementary, secondary or college), such as tuition, books, uniform, etc. It is found at section 530 of the Internal Revenue Code. The account is named for its primary champion in the U.S. Senate, the late Senator Paul Coverdell (RGA).

A Coverdell Education Savings Account (ESA) is a savings account set up to pay the qualified education expenses4 of a child who is its designated beneficiary. When the account is established, the child must be under 18 or a special-needs beneficiary.

The Coverdell ESA, once known as the Education IRA, is the only tax advantaged option for primary and secondary education. All other tax benefits apply strictly towards college and beyond. Unfortunately, there are some changes on the horizon for old Coverdell.

You may invest up to $2,000 annually on an after-tax basis per child in an ESA. Earnings accumulate tax-free, and money withdrawn to pay for qualified education expenses (tuition, fees, books, equipment, room and board) is free from income taxes. Withdrawals may be made for qualified expenses related to education from kindergarten through grade 12 and for undergraduate and graduate education. Contributions must stop when a child reaches age 18. Funds not used for education by the time the child reaches age 30 must be transferred to a younger beneficiary or must be withdrawn, and these funds will be subject to tax on the earnings and a 10% penalty. Although more than one person may contribute to an ESA for the same child, no more than $2,000 for that child can be contributed in any year. The AGI limit for married taxpayers is $220,000 ($110,000 for single taxpayers); taxpayers claiming an education tax credit can exclude from gross income an ESA distribution used for other qualified expenses; and contributions to both an ESA and a 529 plan are allowed.

Qualification:

If your modified adjusted gross income (MAGI) is less than $110,000 for a single taxpayer or $220,000 for married taxpayers filing jointly, you can establish a Coverdell ESA to finance the qualified education expenses of a designated beneficiary who is under age 18 or is a special-needs beneficiary. The account must also be designated as a Coverdell ESA when it is created. Organizations such as corporations and trusts can contribute to Coverdell ESAs; however, the contributions must be in cash, made before the designated beneficiary turns 18 (unless the child is a special-needs beneficiary), and they must be made by the due date of the contributor’s tax return (not including extensions).

For 2009, there is no limit on the number of separate Coverdell ESAs that can be established for a beneficiary, but the total of all contributions cannot exceed $2,000 per child, no matter how many savings accounts have been set up for a single designated beneficiary.

ESAs and 529 plans let you, the account owner, set up investment accounts for a beneficiary, or recipient, that you designate. This differs greatly from a custodial account where the child takes over at 18 and can do with the money whatever they want. Go ahead and let your imagination run rampant here parents. Within these investment plans, your earnings and any capital gains accumulate tax deferred, which means you put off paying taxes until your money is withdrawn.

How do you get it?

The designated beneficiary of a Coverdell ESA can take a distribution at any time. Generally, the distributions are tax free if they are not more than the beneficiary’s adjusted qualified education expenses for the year.

At the end of the year, the beneficiary must pay a 6 percent excise tax on excess contributions in a Coverdell ESA.

When is it available?

When a student is enrolled at an eligible postsecondary school, the savings account can be withdrawn to pay for qualified higher education expenses. These include tuition and fees; books, supplies and equipment; special-needs services (for a special-needs beneficiary); and room and board, so long as the beneficiary is enrolled at least half time.

No contributions can be made to a designated beneficiary after he or she reaches age 18, unless the student is a special-needs beneficiary.

Can a family claim multiple benefits?

The American Opportunity/Hope or Lifetime Learning credit can be claimed in the same year the beneficiary takes a tax-free distribution from a Coverdell ESA as long as the same expenses are not used for both benefits.

Contributions can be made without penalty to both a Coverdell ESA and a qualified tuition program (QTP) in the same year for the same beneficiary. However, if the total distribution is more than the beneficiary’s adjusted qualified higher education expenses, those expenses must be allocated between the distributions from the Coverdell ESA and the QTP before figuring how much of each distribution is taxable.

Coverdell Esa at a Glance

QUESTION ANSWER
What is a Coverdell ESA? A savings account that is set up to pay the qualified education expenses of a designated beneficiary
Where can it be established? It can be opened in the United States at any bank or other IRS-approved entity that offers Coverdell ESAs
Who can have a Coverdell ESA? Any beneficiary who is under age 18 or is a special-needs beneficiary
Who can contribute to a Coverdell ESA? Generally, any individual (including the beneficiary) whose modified adjusted gross income for the year is less than $110,000 ($220,000 in the case of a joint return)
Are distributions tax free? Yes, if the distributions are not more than the beneficiary’s adjusted qualified education expenses for the year
Are contributions deductible? No
Why should someone contribute to a Coverdell ESA? Earnings on the account grow tax free until distributed
What is the annual contribution limit per designated beneficiary? Cash-only contributions of $2,000 for each designated beneficiary, no matter how many Coverdell ESAs are set up for that beneficiary or how many individuals contribute
When must contributions stop? No contributions can be made to a beneficiary’s Coverdell ESA after he or she reaches age 18, unless the beneficiary is a special-needs beneficiary

Here are some things to remember about Distributions from Coverdell Accounts:

Coverdell Tax Breaks Ending 2011

Unfortunately, starting in 2011, any earnings you withdraw will be taxed as ordinary income and subject to a 10% penalty unless they are used for college expenses. In other words, your original contributions are not taxed but the appreciation will be. In addition, the maximum annual contribution will fall from $2,000 to a mere $500.
Note: Information courtesy of: Internal Revenue Service Publication 970 "Tax Benefits for Education"

For Your Information (FYI):
Contributions to a Coverdell ESA are not tax deductible, but earnings in the account are tax free as long as the funds are used for qualified education expenses. This information’s covers a variety of important tax topics related to higher education. It is intended for your educational use and not as legal or tax advice; it does not cover every facet or the full scope of this subject. We highly recommend that you consult a professional tax advisor or attorney and encourage you to visit the Internal Revenue Service Web site, where you will find the complete text of various relevant IRS publications.

IRS Publications

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