Coverdell Education Savings Accounts (ESAs)

A Coverdell ESA (formerly Education IRA) is an education savings program authorized by Code Sec. 530 and set up as a trust or custodial account for a designated beneficiary.

This program was greatly expanded in 2002. Coverdell ESAs can now be used to finance elementary and secondary educational expenses.

A designated beneficiary is any child under 18. Thus, a beneficiary need not be the taxpayer's child, and there is no relationship requirement.

The beneficiary can be the taxpayer's grandchild, niece or nephew, or even a next-door neighbor.

A taxpayer can open Coverdell ESAs at any bank or other institution approved to serve as trustee or custodian.

The savings plan is set up as a trust. The savings plan may or may not provide for guaranteed returns.

Earnings on Coverdell ESA investments are not subject to tax when earned. Distributions are excludable from the income of the beneficiary to the extent they do not exceed qualified education expenses incurred during the year the distributions are made.

The term "qualified education expenses" is liberally defined to include the following:

• Tuition
• Fees
• Room and board if the beneficiary is enrolled on an at least half-time basis. Room and board is the posted rate by the school, or $2,500 per year for students living off-campus but not at home.

A taxpayer may contribute to a Coverdell ESA even if the taxpayer also makes contributions to a qualified tuition program.

Money Saving Tip. If a taxpayer receives tax-free distributions from a Coverdell ESA, the taxpayer may claim a Hope scholarship credit or Lifetime Learning credit that year, provided that both the Coverdell ESA withdrawal and either the Hope or Lifetime Learning credit are not being used toward the same expense.

Contribution Limits

Contributions are limited to a total of $2,000 per year on behalf of any designated beneficiary. The $2,000 limit is an aggregate figure (i.e., contributions can be placed in a single Coverdell ESA or in multiple Coverdell ESAs).

If more than $2,000 is contributed per child (for example, a parent contributes $2,000 and an aunt contributes $400), the excess over $2,000 ($400 in this instance) is treated as an excess contribution. If excess contributions are not withdrawn from the child's account by the due date of the tax return, a 6% penalty applies.

Contributions must be made only in cash. Property contributions, such as stock, are not allowed.

Generally, the gift tax treatment of Coverdell ESA contributions is the same that applies to qualified tuition programs, discussed earlier. However, the five-year rule for contributions does not apply.

Income Limit on Contributor

A taxpayer may make a full contribution only if modified adjusted gross income (MAGI) is no more than $190,000 on a joint return ($95,000 for singles). The contribution limit phases out for MAGI between $190,000 and $220,000 on a joint return (between $95,000 and $110,000 for singles).