Understanding the Coverdell Education Savings Account

A Coverdell Education Savings Account (ESA) is a special account, qualified by the Internal Revenue Service, which provides tax incentives for saving for education. Contributions to a Coverdell account are not tax-deductible, but tax-free earnings can accumulate in the account. And distributions from the account are tax free when they are used to pay for qualified education expenses, including elementary, secondary school, college and other postsecondary education.

How a Coverdell ESA works
You can set up a Coverdell account for your child, another beneficiary under age 18 or a special needs beneficiary. The account can be opened at a bank or financial institution authorized by the IRS to offer Coverdell accounts. When you open the account it must be specifically designated as a Coverdell ESA in order to take advantage of the tax incentives.

Anyone can contribute to the Coverdell account, including the beneficiary, provided their modified adjusted gross income for federal income tax purposes is not more than $110,000 or $220,000 for married taxpayers filing jointly. But there is a gradual phase out of the amount that can be contributed when modified adjusted gross income is from $95,000 to $110,000 or $190,000 and $220,000 for a married couple.

Contributions to the account must be made in cash, not in securities or other property, and there is a limit of $2,000 per year on the total amount that can be contributed per beneficiary. If more than one person contributes, the total contributions to all the beneficiary's Coverdell accounts cannot exceed $2,000 per year. Excess contributions are subject to an excise tax of six percent.

Contributions can be made to the Coverdell account until the beneficiary reaches age 18. In order to preserve the tax-free treatment of earnings, the balance in the account must be used to pay for qualified education expenses before the beneficiary reaches 30.

Qualifying education expenses and tax on excess distributions
Distributions from a Coverdell account must be used to pay for the beneficiary's costs of tuition, fees, books, supplies and equipment required for enrollment in a primary or secondary school, college or other postsecondary institution. Room and board, uniforms and transportation also qualify if they are required or provided by the school. A postsecondary student must be enrolled at least half time.

The beneficiary of a Coverdell ESA can withdraw funds from the account at any time. The withdrawal will not be taxable provided the amount withdrawn is less than or equal to the beneficiary's qualified education expenses during the year less any tax-free educational assistance the beneficiary receives, such as scholarships or fellowships, veterans' educational assistance, Pell grants or educational assistance provided by an employer.

If the amount the beneficiary withdraws from the Coverdell account is more than the qualified educational expenses, the part that represents the tax-free, accumulated earnings in the account would be subject to tax. There is also a 10-percent additional tax on excess withdrawals except when the beneficiary is disabled, or the amounts had to be included in income because the beneficiary received tax-free educational assistance or is claiming the Hope Learning Credit or Lifetime Learning Credit.

How a Coverdell ESA affects other education benefits
A tax-free distribution can be taken from a Coverdell ESA in the same year that a Hope or Lifetime tax credit is taken for education expenses provided the tax benefits are not calculated based on the same expenses. To determine how much can be withdrawn from the Coverdell account without incurring any tax liability, you need to take your total qualified education expenses and subtract any tax-free educational assistance you receive and the amount of education expenses taken into account in figuring the Hope or Lifetime credits.

Coverdell account versus 529 plans
Another type of tax-favored education savings plan is the Section 529 plan. A 529 plan is similar to a Coverdell ESA in that earnings can accumulate tax free in the account and distributions are not taxable if they are used to pay qualified education expenses. As in the case of a Coverdell account, when distributions from a 529 plan exceed the amount of qualified education expenses, the earnings portion of the difference is subject to income tax plus 10-percent additional tax.

But there are some differences between a Coverdell ESA and a 529 plan. 529 plans are generally established by the individual states or by educational institutions, although there is also a national Independent 529 Plan. With a 529 plan you can either prepay tuition directly to the educational institution or contribute to a savings account. 529 plans are for postsecondary education and do not cover elementary and secondary education.

There are no maximum income limitations for contributing to a 529 plan and there are no age limits. The donor, who sets up a 529 plan for themselves or someone else, keeps control of the account and the beneficiary generally does not have access to the funds. Contributions to a 529 plan cannot be more than the amount necessary to finance the beneficiary's education expenses, but there is no specific dollar limit per year.

Another significant difference is that contributions to a 529 plan may be tax deductible for state income tax purposes. On the Web site FinAid!, The SmartStudent™ Guide to Financial Aid, at www.finaid.org, there is a table showing the different states and the deductions they allow for contributions to a 529 plan.

Combining the benefits of a Coverdell ESA and a 529 plan
You may be able to combine the tax benefits of a Coverdell ESA and a 529 plan the year the beneficiary graduates from high school and enters college or some other postsecondary school. A distribution from the Coverdell account could be used to cover any high school expenses, which are qualified expenses for the Coverdell account but not the 529 plan and take a distribution from the 529 plan and the Coverdell account to cover the postsecondary education expenses, which may qualify under both plans.