Coverdell Education Savings Account (ESA) or 'Education IRA'

A brief history

Previously under the misnomer "Education IRA", this little-known, tax-deferred savings tool for educational expenses has been largely ignored, and not without good reason. Under prior tax laws which limited the annual EIRA contributions to $500 per beneficiary, the EIRA didn't offer up much more than the lure of a little extra tax-free income. However, a name change and new tax laws beginning in 2002 have transformed this savings account into a valuable education savings vehicle for many people, including those who wish to save for pre-college expenses such as private elementary or secondary school tuition. Contribution limits were raised from $500 to $2000 per year/per child.

The ESA was improved when Congress approved, and President Bush signed a breakthrough measure of tax relief to help with the costs of a child's education. The relief is intended to help with not only the burden of higher education costs, but also the costs associated with both private and public elementary and secondary schools. The new name comes from the late Paul Coverdell, a Georgian senator who fought for this measure to come about.

With higher education costs climbing steadily upward at nearly 8% per year, the IRS' dramatic re-vamping of the new Coverdell Education Savings Account comes none too soon. As college cost projections continually increase, many families are particularly concerned about accumulating enough money to put their children through college. Based on the latest averages from The College Board and recent average annual college cost increases, a child who entered kindergarten in 1995 will face four-year college costs of nearly $100,000 if he or she chooses to attend a public college in 2009. For a private college, costs will probably be double that.

What changes are now in effect?

Contribution of military death gratuity to Coverdell ESA.

The families of soldiers killed in the line of duty may contribute, subject to certain limitations, up to 100 percent of survivor benefits to education savings accounts.
Withdrawal of economic stimulus payment from a income for the year is less than Coverdell ESA.

If your economic stimulus payment was directly deposited to your ESA and you withdraw the payment by the later of June 1, 2009, or the due date of your return (including extensions), the amount withdrawn will not be taxed and no additional tax or penalty will apply.

What exactly is a Coverdell ESA?

A Coverdell ESA is a trust or custodial account established in the United States only to pay for the qualified education expenses of a designated beneficiary. At the time of contributions, the beneficiary must be under age 18 or he or she needs to be a special needs beneficiary.

The account must be designated a Coverdell ESA or equivalent when it is created. The custodian must be a bank (e.g., PENSCO) or entity approved by the IRS. Contributions must be in cash and total contributions per beneficiary cannot exceed $2,000 per year. Money cannot be invested in life insurance contracts. The balance of the account must be distributed within 30 days after the earlier of the following:

The beneficiary reaches the age 30, unless the beneficiary is a special needs beneficiary.
The beneficiary's death.

How does it work?

Essentially, if you are familiar with the characteristics and functions of a Roth IRA, you now understand the Coverdell ESA, as they offer similar benefits. Like into a Roth IRA, contributions into an ESA are not tax deductible; they are made with after-tax dollars. This means that any future withdrawals of contributed funds will be tax-free, though any earnings withdrawn may be taxable. However, if withdrawn to cover qualified expenses, earnings too will remain entirely tax-free. One major distinction between the Roth IRA and the ESA: while a Roth IRA is intended to provide for the retirement years, the Education Savings Account is an investment vehicle targeted at a youth's educational expenses (incurred before their 30th birthday).

What is considered a qualified educational expense?

Your child will be able to make a tax-free withdrawal in any year to the extent that she or he incurs qualified higher education expenses (QHEE). If your child withdraws more than the amount of QHEE, the earnings portion of that excess withdrawal is subject to income tax and possibly a 10% penalty tax.

The tax laws have expanded the meaning of "qualified education expense(s)" to include those relating to both elementary and secondary education. These expenses may include tuition, fees, academic tutoring, special needs services, books, supplies, and other equipment (including computing equipment and Internet access expenses) which are incurred in connection to the beneficiary's enrollment at an eligible educational institution. Allowable expenses for K-12 also include room and board (provided the student is enrolled at least half-time), uniforms, transportation, and supplementary items and services (including extended day programs), as well as computer technology or equipment - even internet access, as long as such technology or equipment is used by the beneficiary or their family for educational purposes as defined by the IRS. For example, video games or software relating to sports, games or hobbies that is not predominantly educational in nature would not qualify.

Note also that the child's amount of qualified higher education expenses will be reduced by any other tax-free benefits received in that year. In essence, the IRS will not allow your child to "double-dip" into multiple tax-free benefit plans for overlapping expenses.

What qualifies as an eligible educational institution?

An eligible educational institution is any college, university, vocational school, postsecondary, secondary or elementary school that is eligible to participate in student aid programs administered by the Department of Education. For a list of institutions that qualify under this definition, please go to http://www.fafsa.ed.gov.

How do I establish a Coverdell ESA?

First of all, make sure that you and the designated beneficiary are eligible for opening and funding an ESA. Is the designated beneficiary under the age 18? There are no stipulations regarding the relationship between the contributor and the beneficiary, so as long as the beneficiary is under 18, he or she could be your child, grandchild, niece, nephew or neighbor, as far as the IRS is concerned. You may still make contributions after the child's 18th birthday if they are a special needs beneficiary. A child is eligible for an ESA account beginning the day they are born, so it is never too early to start. Contributions are not dependent on the child's earned income.

Are you eligible to make a contribution?

Before contributing, you must establish that your modified adjusted gross income (MAGI) falls within the eligible limits for the year in which you wish to contribute. To qualify for the full $2,000 contribution, a contributors' MAGI must be less than $95,000 ($220,000 for those filing a joint tax return). The $2,000 contribution limit is gradually phased out for those of you with modified adjusted gross income falling between $95,000 and $110,000 ($190,000 and $220,000 for joint filers). Go to www.irs.com and download Publication 970 (Tax Benefits for Education). On page 46, calculate the amount you are eligible to contribute.

Second, you need to choose an institution to house your Coverdell Education Savings Account. Any trust company, bank, mutual fund company or other financial institution that is a licensed custodian for traditional IRAs should be able to accommodate an ESA. The deciding factor between custodians then, will be the varying costs and investment options associated with each institution. Make sure to weigh both costs and options together to discover where the most opportunity for tax-free growth lies.

For example, if one institution charges a lower fee but limits the investment choices to two mutual funds earning approximately 4%, it might make more sense to choose an account with a self-directed custodian. While they will generally charge a higher service fee, they will also allow you to self-direct the funds into any investment of your choice - including one that may make a 20% annual return. It is a good idea to project the accounts' possible earnings, subtract the varying associated costs, and then see which institution may be able to provide you with the greatest net return.

What if my income is too high for me to contribute?

If you are not eligible to contribute because your income is above the allowable limit, do not despair. Unlike an IRA, there is no requirement that the contributor have earned income. Therefore, there is no reason that you cannot gift the funds first to the child, who (assuming that they do fall below the allowable income limit) may then contribute to their own Coverdell Education Savings Account.

Can anyone else contribute?

In addition to the child's parents, friends and relatives may also contribute. And as provided by the new tax laws, other non-related taxpayers, including corporations and other entities (including tax-exempt charitable organizations) are now permitted to make contributions to an ESA regardless of the entity's annual income.

How much can we contribute & by what time?

ESA Contribution deadlines have now been extended. You may now make your contributions after December 31 and apply them to the prior year, as long as you contribute before the April 15th filing deadline (not including extensions).

Although $2000 per year may not seem like enough in the face of gargantuan college tuition costs looming in the future, this is, unfortunately, the annual contribution limit for ESA(s) per child. You may make the full contribution to one single ESA account, or you and seven aunts and uncles can open eight separate accounts for your child, but it still remains that the total annual contribution limit per child is $2,000. While there is no imposed limit on the number of ESAs per child (as long as the total contributions are no more than $2000/year), it often makes little sense to hold multiple accounts when weighing the low contribution limits against associated maintenance fees.

If in error, more than $2,000 is contributed in a year towards your child's ESA(s), the excess contributions and their earnings will be subject to a 6% excise tax penalty. You may avoid this penalty if you withdraw the excess contributions (and their earnings) before the due date of the beneficiary's tax return for that year. Now, while everyone you know may be entitled to open and contribute to an ESA for your child, you may be wondering how you will keep track of excess contributions. Most likely, the institutions sponsoring each Coverdell ESA will issue an IRS Form 5498 showing contribution information for that year. This should give you enough time to make any necessary amendments before the April 15th deadline.

Setting up the ESA

Once you have established eligibility and chosen the sponsoring institution, setting up the account should be a cakewalk. You will need to fill out PENSCO Trust Company's ESA Paperwork in which you will designate the "beneficiary" and a "responsible individual" for the account. Then you will make a cash contribution. (ESA contributions must always be in cash.) Take note also, that due to the Tax Relief Reconciliation Act of 2001, you can now make contributions to a Coverdell ESA and a qualified tuition program (i.e. a 529 plan) in the same year for the same beneficiary.

How is my contribution treated as far as gift tax is concerned?

Contributions to Coverdell ESAs are considered taxable gifts, but are eligible for the $12,000 (in 2009) per donor gift tax exclusion. If you are simultaneously contributing to a 529 plan for the same child, keep in mind that you must list both contributions when determining your gift tax filings. Tax rulings are still unclear on how the gift tax will apply when one beneficiary rolls their ESA over to the benefit of another beneficiary. Though according to tax law, the gift rules should follow those of the 529 plans. Hence a rollover of the ESA will be considered a gift from one beneficiary to the other, but only if the new beneficiary is at least one generation below the original one.

When must the funds be withdrawn?

The ESA beneficiary must have taken a full distribution of the account on or before his or her 30th birthday (unless he or she is a special needs beneficiary.) If this does not occur, the remaining funds will be paid out within 30 days. The earnings will then be subject to tax and the additional 10% penalty tax. However, it is possible to avoid the penalty taxes altogether by rolling the account over to an ESA of another younger family member, or by changing the beneficiary of the account to another younger family member. An amount is considered rolled over if it is withdrawn and then deposited into another Coverdell ESA within 60 days.

If your economic stimulus payment was directly deposited to your Coverdell ESA and you withdraw the payment by the later of June 1, 2009, or the due date of your 2008 return (including extensions), the amount withdrawn will be tax-free. Do not report this withdrawal on your 2008 tax return.

Who qualifies as members of the beneficiary's family?

According to the IRS, the beneficiary's spouse, and the following individuals (and their spouses) are members of the beneficiary's family.

The beneficiary's child, grandchild, or stepchild.
A brother, sister, half brother, half sister, stepbrother, or stepsister of the beneficiary.
The father, mother, grandfather, grandmother, stepfather, or stepmother of the beneficiary.
A brother or sister of the beneficiary's father or mother.
A son or daughter of the beneficiary's brother or sister.
The beneficiary's son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, or sister-in-law.

An ESA may be transferred (either by changing the designated beneficiary, or by rolling over the funds) to another family member at any time with no tax consequences if the receiving (new) beneficiary is under age 30 at the time.

However, please take note that only one rollover per Coverdell ESA is allowed during the 12-month period ending on the date of the payment or withdrawal.

Possible disadvantages or limitations of the ESA:

Some possible disadvantages or limitations of the ESA:

Because of age-restricted eligibility requirements, older adults with college plans are not eligible.
The relatively low contribution caps mean that even a minimal maintenance fee charged by the holding institution may significantly affect your overall investment return.
Because your contribution goes into an account intended solely for your child's educational purposes, you are not able to later refund the account back to yourself as you are with most 529 plans. This causes you to lose some degree of control.
Because an ESA is considered an asset of the student rather than the contributor, it can sometimes be a disadvantage to lower or middle-income families whose children may have otherwise qualified for financial aid. Withdrawals taken during college will also count as the student's income, making it more difficult to qualify for aid in the following year.
To avoid tax penalties, the ESA must be fully withdrawn before the beneficiary's 30th birthday. However, these penalties can be easily avoided by rolling the ESA over to a younger member of the family (see explanation above).

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