Coverdell ESA

Section 530(b)(1) defines the term Coverdell education savings account as a trust created or organized in the United States exclusively for the purpose of paying the qualified education expenses of an individual who is the designated beneficiary of the trust, and designated as a Coverdell education savings account at the time created or organized, but only if the written governing instrument creating the trust meets five requirements. Under subparagraph (A), no contribution will be accepted unless it is in cash, no contribution will be accepted after the date on which such beneficiary attains age 18, and, except in the case of rollover contributions, no contribution will be accepted if such contribution would result in aggregate contributions for the taxable year exceeding two thousand dollars. 

Under subparagraph (B), the trustee is a bank, as defined in section 408(n), or another person who demonstrates to the satisfaction of the Secretary that the manner in which that person will administer the trust will be consistent with the requirements of the section or who has so demonstrated with respect to any individual retirement plan. Under subparagraph (C), no part of the trust assets will be invested in life insurance contracts. Under subparagraph (D), the assets of the trust shall not be commingled with other property except in a common trust fund or common investment fund. Under subparagraph (E), except as provided in subsection (d)(7), any balance to the credit of the designated beneficiary on the date on which the beneficiary attains age 30 shall be distributed within 30 days after such date to the beneficiary or, if the beneficiary dies before attaining age 30, shall be distributed within 30 days after the date of death of such beneficiary.

The flush language at the end of Section 530(b)(1) provides that the age limitations in subparagraphs (A)(ii) and (E), and paragraphs (5) and (6) of subsection (d), shall not apply to any designated beneficiary with special needs, as determined under regulations prescribed by the Secretary.

Coverdell ESAs are a type of trust or custodial account that offers a tax-advantaged way to pay for education. Section 530(g) provides that, for purposes of the section, a custodial account shall be treated as a trust if the assets of such account are held by a bank, as defined in section 408(n), or another person who demonstrates, to the satisfaction of the Secretary, that the manner in which he will administer the account will be consistent with the requirements of the section, and if the custodial account would, except for the fact that it is not a trust, constitute an account described in subsection (b)(1). It also provides that, for purposes of the title, in the case of a custodial account treated as a trust by reason of the preceding sentence, the custodian of such account shall be treated as the trustee thereof.

There are certain requirements to set up a Coverdell ESA. When the account is established, the designated beneficiary must be under the age of 18 or be a special needs beneficiary. The account must be designated as a Coverdell ESA when it is created. The document creating and governing the account must be in writing, and it must meet certain requirements.

Qualified Education Expenses

Section 530(b)(2)(A) defines the term qualified education expenses as qualified higher education expenses, as defined in section 529(e)(3), and qualified elementary and secondary education expenses, as defined in paragraph (3).

Section 529(e)(3)(A) defines the term qualified higher education expenses as tuition, fees, books, supplies, and equipment required for the enrollment or attendance of a designated beneficiary at an eligible educational institution, and expenses for special needs services in the case of a special needs beneficiary which are incurred in connection with such enrollment or attendance.

Section 529(e)(3)(B) provides that, in the case of an individual who is an eligible student, as defined in section 25A(b)(3), for any academic period, the term also includes reasonable costs for such period, as determined under the qualified tuition program, incurred by the designated beneficiary for room and board while attending such institution.

Section 530(b)(3)(A) defines the term qualified elementary and secondary education expenses in three clauses. Clause (i) covers expenses for tuition, fees, academic tutoring, special needs services in the case of a special needs beneficiary, books, supplies, and other equipment which are incurred in connection with the enrollment or attendance of the designated beneficiary of the trust as an elementary or secondary school student at a public, private, or religious school. 

Clause (ii) covers expenses for room and board, uniforms, transportation, and supplementary items and services, including extended day programs, which are required or provided by a public, private, or religious school in connection with such enrollment or attendance. Clause (iii) covers expenses for the purchase of any computer technology or equipment or Internet access and related services, if such technology, equipment, or services are to be used by the beneficiary and the beneficiary's family during any of the years the beneficiary is in school. Clause (iii) shall not include expenses for computer software designed for sports, games, or hobbies unless the software is predominantly educational in nature.

Section 530(b)(3)(B) defines the term school as any school which provides elementary education or secondary education, kindergarten through grade 12, as determined under State law. Section 530(b)(3)(C) defines the term computer technology or equipment as computer software, as defined by section 197(e)(3)(B), computer or peripheral equipment, as defined by section 168(i)(2)(B), and fiber optic cable related to computer use.

Section 530(b)(2)(B) provides that qualified education expenses shall include any contribution to a qualified tuition program, as defined in section 529(b), on behalf of the designated beneficiary, as defined in section 529(e)(1), but there shall be no increase in the investment in the contract for purposes of applying section 72 by reason of any portion of such contribution which is not includible in gross income by reason of subsection (d)(2).

One advantage that Coverdell ESAs have over other tax-advantaged saving options is that tax-free withdrawals can pay for eligible elementary and high school expenses, for example special needs services, tutoring and private school tuition, as well as post-secondary school expenses.

Contributions and the Contribution Limit

Section 530(b)(1)(A) provides that no contribution will be accepted unless it is in cash, that no contribution will be accepted after the date on which the beneficiary attains age 18, and that, except in the case of rollover contributions, no contribution will be accepted if the contribution would result in aggregate contributions for the taxable year exceeding two thousand dollars. Contributions must be made in cash, and they are not deductible.

Any individual whose modified adjusted gross income is under the limit set for a given tax year can make contributions. Organizations, such as corporations and trusts, can also contribute regardless of their adjusted gross income. Contributors must contribute by the due date of their tax return, not including extensions.

There is no limit to the number of accounts that can be established for a particular beneficiary. However, the total contribution to all accounts on behalf of a beneficiary in any year cannot exceed two thousand dollars.

Section 530(b)(4) provides that an individual shall be deemed to have made a contribution to an education individual retirement account on the last day of the preceding taxable year if the contribution is made on account of such taxable year and is made not later than the time prescribed by law for filing the return for such taxable year, not including extensions thereof.

Reduction of Permitted Contributions Based on Income

Section 530(c)(1) provides that, in the case of a contributor who is an individual, the maximum amount the contributor could otherwise make to an account under the section shall be reduced by an amount which bears the same ratio to such maximum amount as the excess of the contributor's modified adjusted gross income for such taxable year over ninety-five thousand dollars, or one hundred ninety thousand dollars in the case of a joint return, bears to fifteen thousand dollars, or thirty thousand dollars in the case of a joint return.

Section 530(c)(2) provides that, for purposes of paragraph (1), the term modified adjusted gross income means the adjusted gross income of the taxpayer for the taxable year increased by any amount excluded from gross income under section 911, 931, or 933.

Tax on Excess Contributions

Section 4973(a) lists a Coverdell education savings account, as defined in section 530, among the accounts for which there is imposed for each taxable year a tax in an amount equal to 6 percent of the amount of the excess contributions to such individual's accounts or annuities, determined as of the close of the taxable year.

Section 4973(e)(1) provides that, in the case of Coverdell education savings accounts maintained for the benefit of any one beneficiary, the term excess contributions means the sum of two amounts. The first is the amount by which the amount contributed for the taxable year to such accounts exceeds two thousand dollars, or, if less, the sum of the maximum amounts permitted to be contributed under section 530(c) by the contributors to such accounts for such year. The second is the amount determined under that subsection for the preceding taxable year, reduced by the sum of the distributions out of the accounts for the taxable year, other than rollover distributions, and the excess, if any, of the maximum amount which may be contributed to the accounts for the taxable year over the amount contributed to the accounts for the taxable year.

Section 4973(e)(2) provides that, for purposes of paragraph (1), two contributions shall not be taken into account. They are any contribution which is distributed out of the Coverdell education savings account in a distribution to which section 530(d)(4)(C) applies, and any rollover contribution.

Section 530(d)(4)(C), titled Contributions returned before certain date, provides that the additional tax in subparagraph (A) shall not apply to the distribution of any contribution made during a taxable year on behalf of the designated beneficiary if such distribution is made before the first day of the sixth month of the taxable year following the taxable year, and such distribution is accompanied by the amount of net income attributable to such excess contribution. Any net income described in clause (ii) shall be included in gross income for the taxable year in which such excess contribution was made.

Investments

Coverdell ESAs offer broader investment options than 529 plans, but contributions are limited. Except for investing in life insurance contracts, there are no investment restrictions for funds in a Coverdell ESA. Section 530(b)(1)(C) provides that no part of the trust assets will be invested in life insurance contracts, and Section 530(b)(1)(D) provides that the assets of the trust shall not be commingled with other property except in a common trust fund or common investment fund.

Because of the fairly low contribution limits of Coverdell ESAs, even small annual fees or expenses could make a big difference in the value of an investment over time.

Distributions and Tax Treatment

Earnings in Coverdell ESAs are tax-deferred, and withdrawals that are used to pay for qualified education expenses are tax-free.

Section 530(d)(1) provides that any distribution shall be includible in the gross income of the distributee in the manner as provided in section 72. Section 530(d)(2)(A) provides that no amount shall be includible in gross income under paragraph (1) if the qualified education expenses of the designated beneficiary during the taxable year are not less than the aggregate distributions during the taxable year. Section 530(d)(2)(B) provides that, if such aggregate distributions exceed such expenses during the taxable year, the amount otherwise includible in gross income under paragraph (1) shall be reduced by the amount which bears the same ratio to the amount which would be includible in gross income under paragraph (1), without regard to the subparagraph, as the qualified education expenses bear to such aggregate distributions.

In general, the designated beneficiary of a Coverdell ESA can receive tax-free distributions to pay qualified education expenses. The distributions are tax-free to the extent the amount of the distributions does not exceed the beneficiary's qualified education expenses. If a distribution exceeds the beneficiary's qualified education expenses, a portion of the earnings is taxable to the beneficiary.

Section 530(d)(2)(C)(i), titled Credit coordination, provides that the total amount of qualified education expenses with respect to an individual for the taxable year shall be reduced as provided in section 25A(g)(2), and by the amount of such expenses which were taken into account in determining the credit allowed to the taxpayer or any other person under section 25A. 

Section 530(d)(2)(C)(ii), titled Coordination with qualified tuition programs, provides that, if with respect to an individual for any taxable year the aggregate distributions during such year to which subparagraph (A) and section 529(c)(3)(B) apply exceed the total amount of qualified education expenses, after the application of clause (i), for such year, the taxpayer shall allocate such expenses among such distributions for purposes of determining the amount of the exclusion under subparagraph (A) and section 529(c)(3)(B).

Section 530(d)(2)(D) provides that no deduction, credit, or exclusion shall be allowed to the taxpayer under any other section of chapter 1 for any qualified education expenses to the extent taken into account in determining the amount of the exclusion under the paragraph.

Section 530(d)(4)(A), titled Additional tax for distributions not used for educational expenses, provides that the tax imposed by chapter 1 for any taxable year on any taxpayer who receives a payment or distribution from a Coverdell education savings account which is includible in gross income shall be increased by 10 percent of the amount which is so includible. Section 530(d)(4)(B) provides that subparagraph (A) shall not apply if the payment or distribution is made to a beneficiary, or to the estate of the designated beneficiary, on or after the death of the designated beneficiary; attributable to the designated beneficiary's being disabled, within the meaning of section 72(m)(7); made on account of a scholarship, allowance, or payment described in section 25A(g)(2) received by the designated beneficiary to the extent the amount of the payment or distribution does not exceed the amount of the scholarship, allowance, or payment; made on account of the attendance of the designated beneficiary at the United States Military Academy, the United States Naval Academy, the United States Air Force Academy, the United States Coast Guard Academy, or the United States Merchant Marine Academy, to the extent that the amount of the payment or distribution does not exceed the costs of advanced education, as defined by section 2005(e)(3) of title 10, United States Code, as in effect on the date of the enactment of the section, attributable to such attendance; or an amount which is includible in gross income solely by application of paragraph (2)(C)(i)(II) for the taxable year.

Section 530(e), titled Tax treatment of accounts, provides that rules similar to the rules of paragraphs (2) and (4) of section 408(e) shall apply to any Coverdell education savings account. Section 530(f), titled Community property laws, provides that the section shall be applied without regard to any community property laws.

Rollovers and Changes of Beneficiary

Section 530(d)(5) provides that paragraph (1) shall not apply to any amount paid or distributed from a Coverdell education savings account to the extent that the amount received is paid, not later than the 60th day after the date of such payment or distribution, into another Coverdell education savings account for the benefit of the same beneficiary or a member of the family, within the meaning of section 529(e)(2), of such beneficiary who has not attained age 30 as of such date. The preceding sentence shall not apply to any payment or distribution if it applied to any prior payment or distribution during the 12-month period ending on the date of the payment or distribution.

Section 529(e)(2) defines the term member of the family, with respect to any designated beneficiary, to mean the spouse of such beneficiary; an individual who bears a relationship to such beneficiary which is described in subparagraphs (A) through (G) of section 152(d)(2); the spouse of any individual described in subparagraph (B); and any first cousin of such beneficiary.

Section 530(d)(6) provides that any change in the beneficiary of a Coverdell education savings account shall not be treated as a distribution for purposes of paragraph (1) if the new beneficiary is a member of the family of the old beneficiary and has not attained age 30 as of the date of such change.

Certain transfers to members of the beneficiary's family are permitted.

The Age 30 Distribution Rule and Its Exceptions

Amounts remaining in the account must be distributed within 30 days after the designated beneficiary reaches age 30, unless the beneficiary is a special needs beneficiary. If the beneficiary dies before attaining the age of 30, amounts remaining in the account must be distributed within 30 days after the date of death.

Section 530(d)(8) provides that, in any case in which a distribution is required under subsection (b)(1)(E), any balance to the credit of a designated beneficiary as of the close of the 30-day period referred to in such subsection for making such distribution shall be deemed distributed at the close of such period.

Section 530(d)(7), titled Special rules for death and divorce, provides that rules similar to the rules of paragraphs (7) and (8) of section 220(f) shall apply. In applying the preceding sentence, members of the family of the designated beneficiary shall be treated in the same manner as the spouse under such paragraph (8).

Gift and Estate Tax Rules

Section 530(d)(3), titled Special rules for applying estate and gift taxes with respect to account, provides that rules similar to the rules of paragraphs (2), (4), and (5) of section 529(c) shall apply for purposes of the section. The headings of those three paragraphs of section 529(c) are Gift tax treatment of contributions, Estate tax treatment, and Other gift tax rules.

Reports

Section 530(h) provides that the trustee of a Coverdell education savings account shall make such reports regarding such account to the Secretary and to the beneficiary of the account with respect to contributions, distributions, and any other topics the Secretary may require. The reports required by that subsection shall be filed at such time and in such manner and furnished to such individuals at such time and in such manner as may be required.

IRS Topic No. 310 describes Form 1099-Q, titled Payments from Qualified Education Programs (Under Sections 529 and 530), as the form a person should receive from each of the Coverdell ESAs from which the person received a distribution.

Common Misunderstandings

The corrections below come from Section 530 of the Internal Revenue Code, Section 4973 of the Internal Revenue Code, IRS Topic No. 310 and the FINRA college savings page.

Contributions to a Coverdell ESA are deductible. Contributions must be made in cash, and they are not deductible.

A Coverdell ESA is only for college expenses. Section 530(b)(2)(A) defines qualified education expenses to include qualified elementary and secondary education expenses as well as qualified higher education expenses.

Contributions may be made at any age. Section 530(b)(1)(A) provides that no contribution will be accepted after the date on which the beneficiary attains age 18, and the flush language of Section 530(b)(1) provides that the age limitation shall not apply to any designated beneficiary with special needs.

Contributions have no dollar limit. Section 530(b)(1)(A) provides that, except in the case of rollover contributions, no contribution will be accepted if it would result in aggregate contributions for the taxable year exceeding two thousand dollars, and the total contribution to all accounts on behalf of a beneficiary in any year cannot exceed two thousand dollars.

Income does not affect who may contribute. Any individual whose modified adjusted gross income is under the limit set for a given tax year can make contributions, and Section 530(c)(1) reduces the maximum amount a contributor who is an individual could otherwise make.

Only individuals may contribute. Organizations, such as corporations and trusts, can also contribute regardless of their adjusted gross income.

A Coverdell ESA may hold life insurance. Section 530(b)(1)(C) provides that no part of the trust assets will be invested in life insurance contracts.

The balance may remain in the account indefinitely. Section 530(b)(1)(E) requires that any balance to the credit of the designated beneficiary on the date on which the beneficiary attains age 30 be distributed within 30 days after such date.

Every withdrawal is tax-free. Withdrawals that are used to pay for qualified education expenses are tax-free, and if a distribution exceeds the beneficiary's qualified education expenses, a portion of the earnings is taxable to the beneficiary. Section 530(d)(4)(A) also increases the tax on a distribution includible in gross income by 10 percent of the amount which is so includible.

A beneficiary may have only one Coverdell ESA. There is no limit to the number of accounts that can be established for a particular beneficiary, although the total contribution to all accounts on behalf of a beneficiary in any year cannot exceed two thousand dollars.

Key Points

Section 530(b)(1) defines a Coverdell education savings account as a trust created or organized in the United States exclusively for the purpose of paying the qualified education expenses of an individual who is the designated beneficiary of the trust.

Qualified education expenses include qualified higher education expenses and qualified elementary and secondary education expenses.

Section 530(b)(1)(A) provides that no contribution will be accepted unless it is in cash, that no contribution will be accepted after the date on which the beneficiary attains age 18, and that, except in the case of rollover contributions, no contribution will be accepted if it would result in aggregate contributions for the taxable year exceeding two thousand dollars.

Contributions are not deductible, and earnings are tax-deferred.

Withdrawals that are used to pay for qualified education expenses are tax-free.

Section 530(d)(4)(A) increases the tax on a distribution includible in gross income by 10 percent of the amount which is so includible.

Section 530(b)(1)(C) provides that no part of the trust assets will be invested in life insurance contracts.

Section 530(b)(1)(E) requires distribution of the balance within 30 days after the beneficiary attains age 30, subject to the exceptions in Section 530.