What is a Coverdell Education Savings Account (ESA)?
Named Education IRAs when first established in 1998, these accounts were renamed Coverdell Education Savings Accounts (ESA) in 2001. The ESA is a tax-favored account for the purpose of saving for education expenses. ESAs allow contributions for any child under age 18, and tax-free distributions for a broad variety of education expenses up until age 30.
Annual contributions to the ESA may not exceed $2,000 (eligible contributions may be less if the taxpayer's income exceeds certain thresholds). All contributions must be in cash. Like an IRA, an ESA will lose its tax-advantaged status if it is used in a prohibited transaction.
Coverdell ESA Eligibility
Any adult can establish a Coverdell ESA for any child under the age of 18. The person who controls the ESA is the custodian (sometimes referred to as the "responsible party") as named in the account agreement. The child, known as the designated beneficiary, does not have to be related to the person establishing the account.
Aggregate contributions that may be made by all contributors to one (or more) ESA established on behalf of any particular beneficiary are limited to $2,000 for each year. Corporations, tax-exempt organizations and other entities may make contributions to an unlimited number of parties' ESAs.
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Contributions to an ESA may be made up to April 15th (the tax return due date, not including extensions) for a contribution to apply to the preceding year. Any contribution to an ESA is treated as a gift from the contributor to the beneficiary at the time of the contribution, meaning annual contributions are subject to the gift tax exclusion and are excludable for purposes of the generation-skipping transfer tax.
Excise taxes and/or penalties may apply to excess contributions made to ESAs. Contributions are considered excess when they are:
- More than a total of $2,000 per designated beneficiary per year;
- Made in a year when the contributor's adjusted gross income tops the limits for income eligibility;
- Contributed to a designated beneficiary who is 18 years of age or older;
- Made in violation of applicable rollover rules.
Excess contributions, if corrected prior to the tax filing deadline for the year in which the contributions are applied, will avoid related excise taxes and/or penalties.
Coverdell ESA Eligible Expenses
Distributions from your Coverdell Education Savings Account are tax-free provided that they are used to pay the beneficiary's qualified education expenses.
You may use your Coverdell Education Savings Account to pay for the beneficiary's elementary, secondary, and postsecondary expenses at virtually any accredited public, private, or religious school. Qualified education expenses include tuition, fees, books, supplies, and equipment required for attendance at the designated educational institution. Other expenses such as room and board, uniforms, transportation, computer-related expenses, and supplementary items (e.g., extended day programs) may also qualify. Additional exceptions are available to special needs beneficiaries. Qualified education expenses are reduced by the amount of any scholarships or financial aid received.
Please see IRS Publication 970, Tax Benefits for Education, for more information about qualified education expenses.
Coverdell ESA Distribution Rules
The account custodian may request a distribution at any time. Distributions, including earnings, are tax-free as long as they do not exceed the beneficiary's adjusted qualified education expenses. Some tax-free scholarships, fellowships, and grants may reduce the allowable amount of tax-free ESA distributions in a given tax year. Distributions in excess of the beneficiary's adjusted qualified education expenses are generally includable in the beneficiary's taxable income for the year, and may be subject to a 10% IRS tax penalty.
Once the designated beneficiary reaches age 30 (or upon the beneficiary's death), any remaining ESA balance must be distributed within 30 days. Alternatively, amounts remaining in an ESA may be rolled over into another ESA for the education of another beneficiary in the beneficiary's family. A change in beneficiary does not constitute a distribution if the new beneficiary is a member of the family of the original beneficiary.
Taxpayers may claim the HOPE Scholarship/American Opportunity Education Credit or the Lifetime Learning Credit in the same year that a tax-free distribution is made from an ESA. However, the distributions cannot cover the same education expense.
For more information about ESA distributions, including calculating adjusted qualified education expenses, please refer to IRA Publication 970, Tax Benefits for Education.
Coverdell ESA Age Limit
The balance remaining in an ESA must be distributed within 30 days after a beneficiary reaches age 30. Also, distribution of the account balance of a deceased beneficiary must be made within 30 days after death of a beneficiary under age 30.
HOPE Scholarship Credit / American Opportunity Credit
While not part of the Education Savings Account, the HOPE Scholarship Credit (renamed American Opportunity Credit in 2009) does interrelate with the ESA. Taxpayers may be able to claim a nonrefundable HOPE Scholarship/ American Opportunity Education Credit against their federal income taxes. The credit is claimed for the qualified tuition and related expenses of each student in the taxpayer's family who is enrolled at least half-time in one of the first two years of post secondary education and who is enrolled in a program leading to a recognized educational credential. The maximum credit a taxpayer may claim for a taxable year is $2,500 multiplied by the number of students in the family who meet the enrollment criteria. The amount a taxpayer may claim is gradually reduced for taxpayers with modified adjusted gross incomes above $80,000 ($160,000 for joint filers), and phased out at $90,000 ($180,000 for joint filers). See IRS Publication 970 for more information.
Lifetime Learning Credit
The Lifetime Learning Credit also interrelates with the ESA. Taxpayers may be able to claim a nonrefundable Lifetime Learning Credit against their federal income taxes. The credit is claimed for the qualified tuition and related expenses of each student in the taxpayer's family who is enrolled in eligible education institutions. Unlike the HOPE Scholarship/American Opportunity Credit, students are not required to be enrolled at least half-time in one of the first two years of post secondary education. The amount that may be claimed as a credit is equal to 20% of the taxpayer's first $10,000 of out-of-pocket qualified tuition and other expenses for all the students in the family. The amount a taxpayer may claim is gradually reduced for taxpayers with modified adjusted gross incomes above $55,000 ($111,000 for joint filers), and phased out at $65,000 ($131,000 for joint filers).