Why should I consider a Coverdell Education Savings Account?
CESAs are a sensible, tax-advantaged way to save for a child's education. Amounts in the account will generally grow tax free and distributions for qualified higher-education expenses are not subject to tax. In some cases, the tax-advantages of CESAs may result in higher after-tax returns than comparable taxable investments.
Any individual, including the designated beneficiary, can contribute to a child's CESA, provided the contributor's modified AGI (adjusted gross income) is less than $110,000 ($220,000 for married taxpayers filing jointly). If you meet the income qualifications, you may contribute to more than one CESA for the same or different beneficiaries, provided total contributions for any single beneficiary do not exceed $2,000 in any given year. In any tax year, no one may contribute to both a CESA on behalf of a beneficiary and to a qualified state tuition program (529 college savings plans) on behalf of the same beneficiary.
Yes, there are three types of contribution limits.
Limit for each child. No more than $2,000 can be contributed to CESAs for the benefit of a single beneficiary in any given year, exclusive of rollovers. This limit is not affected by the number of CESAs that may be established for the child or the number of persons who may contribute.
Limit for each contributor. The maximum you may contribute for each child for any tax year is $2,000. This limit may be reduced if your modified AGI (adjusted gross income) is between $95,000 and $110,000 (between $190,000 and $220,000 if you file a joint return). If your modified AGI is $110,000 or more ($220,000 or more if filing a joint return), you cannot contribute to anyone's CESA.
Absolute limits. You cannot contribute to a CESA:
after the beneficiary reaches age 18;
in any tax year in which contributions are made to a qualified state tuition program (529 college savings plans) on behalf of the same beneficiary; or
if your modified adjusted gross income is above the phase-out range for your filing status.
Note: the Economic Growth and Tax Relief Reconciliation Act of 2001 allows contributions to be made beyond the age of 18 for individuals with special needs. CESA balances for those with special needs are not required to be distributed by age 30.
If eligible, you can make contributions until the beneficiary reaches age 18. However, contributions can be made for individuals with special needs beyond age 18, and they do not need to be distributed for such individuals at age 30.
Qualified higher-education expenses are expenses required for the enrollment or attendance of the designated beneficiary at an eligible educational institution, including elementary and secondary schools. Qualified higher-education expenses may include tuition, fees, books, supplies, equipment, amounts contributed to a qualified state tuition program, and room and board (subject to certain limitations).
An eligible educational institution is any college, university, vocational school, or other postsecondary educational institution eligible to participate in the student aid programs administered by the Department of Education. This includes virtually any accredited public, nonprofit, or proprietary (privately owned profit-making) postsecondary institution. The Economic Growth and Tax Relief Reconciliation Act of 2001 includes elementary and secondary schools in its definition of eligible educational institutions.
There are a number of reasons why children may not pursue higher-education. Some may wish to pursue career opportunities or other interests. Others may divorce, become disabled, or die. In such cases, it may be necessary to roll over CESA assets or change the designated beneficiary.
Rollovers may be made without tax consequences from one CESA to another for the same designated beneficiary or a member of the designated beneficiary's family. The IRS has specific guidelines regarding who may be counted as a family member. The new beneficiary must be under 30 years of age at the time of the rollover and the rollover must occur within 60 days of withdrawal. Only one rollover per CESA is allowed during the 12-month period ending on the date of the payment or distribution.
Changing the designated beneficiary to an eligible member of the beneficiary's family, as specified by the IRS, is another option. Provided the new beneficiary is under age 30, there are no income-tax consequences for changing the designated beneficiary.
Transfers because of divorce allow you to transfer your interest in a CESA to your spouse or former spouse without tax consequences under a divorce or separation agreement. After the transfer, the interest will be treated as a CESA with the spouse or former spouse as the designated beneficiary.
Generally, a distribution is tax free if it does not exceed the beneficiary's qualified higher-education expenses in a tax year.
If distributions exceed qualified higher-education expenses in a given year, a portion of the amount withdrawn must be included in income and may be subject to tax. If you are the designated beneficiary and you or your parents wish to claim a Hope Scholarship Credit or a Lifetime Learning Credit for qualified higher-education expenses paid with the distribution in any given year, you may waive the tax-free treatment of the distribution and elect to pay any tax that would otherwise be owed on it.
With certain specific exceptions, if you receive a taxable distribution from a CESA, you must pay a 10% early withdrawal penalty on the amount you must include in income. If you are the designated beneficiary, the 10% penalty will not apply to taxable distributions that:
are made to a beneficiary (or your estate) on or after your death
are made because you are disabled, as defined by the IRS
result from your receiving a qualified scholarship, educational assistance allowance, or other payment for educational expenses excludable from gross income (to the extent the distribution is not more than the scholarship, allowance, or payment)
are included in income only because you waived the tax-free treatment
constitute a timely return of an excess contribution and any related earnings
Generally, any assets remaining in the CESA must be withdrawn or distributed within 30 days of the time the designated beneficiary reaches age 30 or dies at a younger age. However, as of January 1, 2002 and thereafter, a designated beneficiary with special needs is not subject to these restrictions.
If assets remain in the account after the 30-day period has ended, any remaining amounts (above the designated beneficiary's qualified higher-education expenses for the year) are considered distributed, includible in income, and subject to a 10% early withdrawal penalty on the portion that represents earnings.
There are no tax consequences if the CESA is rolled over or transferred to an eligible family member, as defined by the IRS, provided the rollover or change in designated beneficiary occurs before the former designated beneficiary reaches age 30.
In recent years, college costs have increased rapidly, with the largest percentage increase in public tuition in 30 years occurring in the 2003-2004 academic year. The average annual tuition at a private college is $19,710, and it is $4,694 at a public college for the 2003-2004 school year. If you include room and board expenses, the average annual cost of one year's college education is $26,854 for private colleges and $10,636 for public colleges.1 When you multiply these costs by four years, factor in inflation, and perhaps even increase the numbers for additional children, you quickly realize the tremendous expense that lies ahead.
Even investing aggressively for a full 18 years, annual investments of only $500 would be extremely unlikely to grow to these amounts. For this reason, while a CESA may be a sound way to begin planning for your children's college education, you may want to include other investments in a comprehensive long-range plan.
College costs may vary substantially depending on whether or not your child attends a public or private college, qualifies for scholarships or other financial aid, pursues a two- or four-year degree, and lives on campus or commutes. The amount a CESA provides will also vary, depending on how long you invest, how much you contribute, and the returns you actually achieve, which may be difficult or impossible to predict.
For more information about CESA provisions, distributions, and taxes, please consult with your tax advisor.
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