Coverdell ESAsa Viable Alternative to Qualified Tuition Plans

In planning their estates, taxpayers have been focusing on Sec. 529 and qualified tuition plans and the benefits donors and beneficiaries can reap. However, in 2002, law changes governing these accounts made the Coverdell Education Savings Account (ESA) an attractive alternative.

Taxpayers can establish Sec. 530 Coverdell ESAs (formerly known as Education IRAs) by setting up a trust specifically to pay qualified education expenses (QEEs) to be incurred by the designated beneficiary of the account. Sec. 529(e)(3) defines QEEs as tuition, room and board, fees, tutoring, services for special-needs students, books, supplies, computer hardware and software (including Internet access), uniforms and transportation. Unlike most other education plans, the Coverdell ESA covers the QEEs of a beneficiary attending elementary or secondary school (i.e., K12).

For a contribution to a Coverdell ESA to qualify, there are both income limits and age requirements. First, under Sec. 530(b)(1)(A)(ii), a beneficiary must be under 18 when the taxpayers make the contribution. However, the beneficiary does not have to completely withdraw the funds invested in the account until he or she attains age 30, according to Sec. 530(b)(1)(E). If the beneficiary has not fully depleted the account by that age, the funds can be transferred to another beneficiary. This transfer is tax-free under Sec. 530(d)(5), as long as the new beneficiary is a qualifying family member under age 30, who withdraws the funds within 30 days of attaining age 30 and deposits them into another Coverdell ESA within 60 days.

Second, the maximum contribution for each beneficiary phases out when the donors adjusted gross income is between $95,000$110,000 ($190,000$220,000 if filing a joint return). Because contributors need not have earned income, it is possible for a child to make the contribution if the parents do not qualify, as long as the childs income does not exceed the limits. The parents can simply gift the money to the child, who then makes the contribution. Contributors must make deposits to the account in cash by the filing date of their original income tax return, without extensions. Under Sec. 530(b)(5), such a contribution is deemed made by the end of the preceding tax year.

The annual contribution limit is $2,000 for each qualifying designated beneficiary. There is no limit to the number of accounts that taxpayers can set up for each beneficiary. However, if they establish multiple Coverdell ESAs with combined contributions exceeding $2,000, the owner of the account (ultimately the child) will incur, under Sec. 4973(a)(4), a 6% excise tax on the excess contributions. According to Sec. 530(d)(4)(C), if the beneficiary withdraws the excess funds and the earnings thereon before the first day of the sixth month of the following year (i.e., June 1 for calendar-year taxpayers), there is no penalty. The donors must include income earned on these excess funds in the year they make the contribution.

Taxpayers make contributions with nondeductible after-tax dollars. Withdrawals of principal contributions are tax free. Generally, the beneficiary may withdraw fund earnings tax free if the amounts do not exceed the QEEs incurred for that year. However, a withdrawal is taxable when it exceeds QEEs incurred during the year. The excess withdrawals that represent the tax-free accumulation of income are subject to tax. If a beneficiary makes a taxable withdrawal, an additional 10% tax applies to the portion of the withdrawal that he or she must include in income. However, the 10% tax does not apply if the withdrawal is (1) made to a beneficiary (or to the estate of a designated beneficiary) on or after the designated beneficiarys death; (2) attributable to the beneficiary being disabled; (3) made on account of a nontaxable payment for education expenses, as described in Sec. 25A(g)(2); or (4) taxable because the QEEs are reduced by the Hope or Lifetime Learning Credit.

Contributions to a Coverdell ESA are completed gifts of a present interest to a qualifying beneficiary, eligible for the $11,000 annual gift tax exclusion. Unlike prior years, taxpayers can now contribute to both a qualified tuition plan and a Coverdell ESA. They would include both contributions in their total annual gifts; this is worth keeping in mind for donors using the five-year gift-tax allocation election. If total contributions exceed the $11,000 annual gift tax exclusion, a gift tax is imposed (or the donors will absorb a portion of their lifetime unified credit).

As of 2002, a beneficiary can make withdrawals from both a qualified tuition plan and a Coverdell ESA, provided that the total amount withdrawn does not exceed QEEs incurred that year. When there are excess withdrawals and the beneficiary has been taking withdrawals from both types of accounts, he or she must allocate the QEEs between the two accounts before computing the taxable amounts.

Before 2002, if individuals could claim either the Hope or Lifetime Learning Credit, they then had to waive the tax-free treatment of withdrawals from a Coverdell ESA. Now, when they benefit from claiming either credit in the same tax year they make withdrawals, no waiver is needed. However, they cannot use expenses pertaining to either credit when figuring nontaxable withdrawals from the Coverdell ESA (i.e., no double-dipping is allowed).

From Stephanie J. Hunt, New York, NY