Understanding Coverdell Education Savings Accounts ("ESAs")

Seeing a child work toward a college degree is a parent's dream. But with rapidly escalating costs of higher education, this dream can become a financial nightmare. A Coverdell Educational Savings Account (ESA) can help parents sleep at night. The main benefits of a Coverdell ESA include:

Unlike state 529 plans, Coverdell ESAs can be used to pay for qualified elementary and secondary education expenses.

Earnings grow on a tax-deferred basis, and distributions are tax-free if the money is used to pay qualified education expenses.

This information provides answers to your questions and can help you decide whether or not a Coverdell ESA is a good choice for you and your family.

GENERAL
What is an ESA?
For whom may an ESA be established?
What is a "special needs beneficiary"?
Where may an individual open an ESA?
How many ESAs may a Designated Beneficiary have?

CONTRIBUTIONS
When may a taxpayer start contributing to an ESA?
How much may be contributed to a Designated Beneficiary's ESA?
What is the deadline for making ESA contributions?
What happens if more than $2,000 is contributed to an ESA on behalf of a Designated Beneficiary in a calendar year?
May contributions other than cash be made to a Designated Beneficiary's ESA?
May contributors take a deduction for contributions made to an ESA?
Are there any restrictions on who can contribute to an ESA?
Do contributors have to have compensation or earned income to make contributions to an ESA?
May a Designated Beneficiary contribute to his or her own ESA?
Does a taxpayer have to be related to the Designated Beneficiary in order to contribute to the Designated Beneficiary's ESA?
May contributions be made to both a qualified tuition program (QTP) and an ESA on behalf of the same Designated Beneficiary in the same taxable year?

DISTRIBUTIONS
May a Designated Beneficiary take a tax-free withdrawal from an ESA to pay qualified education expenses if the Designated Beneficiary is enrolled less than full-time at an eligible educational institution?
Whathappens when a Designated Beneficiary withdraws assets from an ESA to pay for qualified education expenses?
What is an eligible educational institution?
What are "qualified education expenses" for elementary and secondary schools?
What are "qualified education expenses" for post-secondary schools?
What is a "half time" student?
What happens if a Designated Beneficiary withdraws an amount from an ESA but does not have any qualified education expenses to pay in the taxable year he or she makes the withdrawal?
Is the distribution from an ESA taxable if the distribution is contributed to another ESA?
What happens to the assets remaining in an ESA after the Designated
Beneficiary finishes his or her postsecondary education?

Rather than rolling or transferring the money from one ESA to another, may the Designated
Beneficiary of the account be changed from one Designated Beneficiary to another without triggering a tax?

May the Designated Beneficiary or the Designated Beneficiary's parents claim the Hope
Scholarship Credit or Lifetime Learning Credit for the Designated Beneficiary's expenses in a taxable year in which the Designated Beneficiary receives money from an ESA on a tax-free basis?

What if the Designated Beneficiary earns an academic scholarship and the tuition is waived?
When must assets in an ESA be distributed?
Can the ESA be transferred to another individual?
Do any exceptions apply to the distribution requirement when the
Designated Beneficiary dies?

ADDITIONAL PROVISIONS
Transfers
Prohibited Transactions
Using the ESA as Security for a Loan

MISCELLANEOUS
Non-forfeitability
Investment Restrictions
No Commingling
Tax Filing
IRS Form

GENERAL

What is an ESA?

An ESA is a trust or custodial account that is created or organized in the United States exclusively for the purpose of paying the qualified education expenses of the Designated Beneficiary of the account. The account must be designated as an ESA when it is created to be treated as an ESA for tax purposes.

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For whom may an ESA be established?

An ESA may be established for the benefit of any child under age 18. Contributions to the ESA will not be accepted after the Designated Beneficiary reaches his or her 18th birthday, unless he or she is a "special needs" Designated Beneficiary.

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What is a "special needs beneficiary"?

The IRS has not yet defined a special needs beneficiary. This Coverdell ESA will incorporate the definition by reference, once made available.

However, a general definition may include individuals who require additional time to complete their education due to a physical, mental or emotional condition. Taxpayers who believe the special needs beneficiary rules apply to their situation should consult a competent tax advisor for guidance.

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Where may an individual open an ESA?

An individual may open an ESA with any bank, or other entity that has been approved to serve as a non-bank trustee or custodian of an individual retirement account (IRA), and the bank or entity is offering ESAs.

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How many ESAs may a Designated Beneficiary have?

There is no limit on the number of ESAs that may be established designating a particular individual as a Designated Beneficiary. However, in any given taxable year, the total contributions to all the ESAs for one individual as beneficiary may not exceed $2,000.

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CONTRIBUTIONS

When may a taxpayer start contributing to an ESA?

Contributions were first permitted to ESAs on January 1, 1998. Contributions may be made to a Designated Beneficiary's ESA from birth until his or her 18th birthday (unless the Designated Beneficiary is a special needs beneficiary).

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How much may be contributed to a Designated Beneficiary's ESA?

Up to $2,000 per year in aggregate contributions may be made for the benefit of any Designated Beneficiary. The contributions may be placed in a single ESA or in multiple ESAs.

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What is the deadline for making ESA contributions?

Contributions must be made by the contributor's tax return due date excluding extensions. For most taxpayers, the deadline is April 15th.

Contributions made between January 1 and April 15 should include an indication of the tax year the contribution is for. If the tax year is not indicated otherwise, the ESA Trustee or Custodian will report it to the IRS as a current year contribution (the year received).

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What happens if more than $2,000 is contributed to an ESA on behalf of a Designated Beneficiary in a calendar year?

Aggregate contributions for the benefit of a particular Designated Beneficiary in excess of $2,000 for a calendar year are treated as excess contributions. If the excess contributions (and any earnings attributable to them) are not withdrawn from the Designated Beneficiary's account (or accounts) before June 1 of the year following the year for which the contribution was made, the excess contributions are subject to a 6 percent excise tax for each year the excess amount remains in the account.

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May contributions other than cash be made to a Designated Beneficiary's ESA?

No. ESAs are permitted to accept contributions made in cash only.

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May contributors take a deduction for contributions made to an ESA?

No.

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Are there any restrictions on who can contribute to an ESA?

Individuals with a modified adjusted gross income (MAGI) of up to $95,000 ($190,000 for married taxpayers filing jointly) may contribute the full amount of $2,000. For most taxpayers, MAGI is the same as adjusted gross income. For those taxpayers who earn income abroad or receive income from certain American territories or possessions, MAGI will be greater than the adjusted gross income. In those cases, the individual's adjusted gross income will be increased by: (1) certain amounts that the individual earns abroad, (2) amounts effectively connected with the individual's conduct of a trade or business derived from sources in Guam, American Samoa, or the Northern Mariana Islands (if the individual is a resident of the possession where the source of income is located), and (3) amounts derived from sources in Puerto Rico (if the individual is a Puerto Rican resident).

The $2,000 maximum contribution is gradually reduced for individuals with MAGI between $95,000 and $110,000 (between $190,000 and $220,000 for married taxpayers filing jointly). For example, an unmarried taxpayer with MAGI of $96,500 in a taxable year could make a maximum contribution per Designated Beneficiary of $450 for that year.

Taxpayers with MAGI above the $110,000 ($220,000 for married taxpayers filing jointly) cannot make contributions to anyone's ESA.

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Do contributors have to have compensation or earned income to make contributions to an ESA?

No.

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May a Designated Beneficiary contribute to his or her own ESA?

Yes.

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Does a taxpayer have to be related to the Designated Beneficiary in order to contribute to the Designated Beneficiary's ESA?

No.

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May contributions be made to both a qualified tuition program (QTP) and an ESA on behalf of the same Designated Beneficiary in the same taxable year?

Yes.

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DISTRIBUTIONS

May a Designated Beneficiary take a tax-free withdrawal from an ESA to pay qualified education expenses if the Designated Beneficiary is enrolled less than full-time at an eligible educational institution?

Yes. Whether the Designated Beneficiary is enrolled full-time, half-time, or less than half-time, he or she may take a tax-free withdrawal to pay qualified education expenses.

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What happens when a Designated Beneficiary withdraws assets from an ESA to pay for qualified education expenses?

Generally, the withdrawal is tax-free to the Designated Beneficiary to the extent the amount of the withdrawal does not exceed the Designated Beneficiary's qualified education expenses at an eligible educational institution.

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What is an eligible educational institution?

An eligible post-secondary educational institution is any college, university, vocational school, or other postsecondary educational institution that is described in section 481 of the Higher Education Act of 1965 (20 U.S.C. 1088) and, therefore, eligible to participate in the student aid programs administered by the Department of Education. This category includes virtually all accredited public, nonprofit, and proprietary (privately owned profit-making) postsecondary institutions. An eligible elementary or secondary school is any public, private, or religious school that provides kindergarten through grade 12 education as determined under state law.

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What are "qualified education expenses" for elementary and secondary schools?

Expenses are qualified that are related to enrollment or attendance such as tuition, books, supplies, equipment, academic tutoring, and special needs services for a special needs beneficiary. In addition, expenses also qualify that are provided by an eligible school in connection with attendance or enrollment such as room and board, uniforms, transportation, supplementary items and services (including extended day programs). Expenses related to the purchase of computer technology, equipment or Internet access qualify if the items are used by the Designated Beneficiary and his or her family during any of the years the Designated Beneficiary is in school. (This does not include expenses for computer software designed for sports, games or hobbies unless the software is predominantly educational in nature.)

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What are "qualified education expenses" for post-secondary schools?

Expenses are qualified that are related to enrollment or attendance such as tuition and fees, books, supplies, equipment, and special needs services for a special needs beneficiary. In addition, expenses for room and board qualify provided the Designated Beneficiary is at least a half-time student. However, only room and board expenses qualify that do not exceed the greater of
(1) the allowance for room and board, as determined by the eligible educational institution, that was included in the cost of attendance (for federal financial aid purposes) for a particular academic period and living arrangement of the student and
(2) the actual amount charged if the student is residing in housing owned or operated by the eligible educational institution.
Any contribution to a qualified tuition program (QTP) made on behalf of the Designated Beneficiary also is a qualified education expense.

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What is a "half-time" student?

A Designated Beneficiary is a student enrolled "at least half-time" if he or she is enrolled for at least half the full-time academic work load for the course of study the student is pursuing, as determined under the standards of the school where the student is enrolled.

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What happens if a Designated Beneficiary withdraws an amount from an ESA but does not have any qualified education expenses to pay in the taxable year he or she makes the withdrawal?

Generally, if a Designated Beneficiary withdraws an amount from an ESA and does not have any qualified education expenses during the taxable year, a portion of the distribution is taxable. The portion subject to income taxes is the portion that represents earnings that have accumulated tax-free in the account. The taxable portion of the distribution is also subject to a 10 percent tax penalty as well unless:
a. The withdrawal is paid to the estate of the Designated Beneficiary within 30 days of his or her death;
b. The withdrawal is paid to the Designated Beneficiary due to his or her disability; or
c. The withdrawal is equal to or less than the amount of a scholarship or other tax-free educational assistance received by the Designated Beneficiary.

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Is the distribution from an ESA taxable if the distribution is contributed to another ESA?

Any amount distributed from an ESA and rolled over or transferred to another ESA for the benefit of the same Designated Beneficiary or certain members of the Designated Beneficiary's family is not taxable. An amount is rolled over if it is paid to another ESA on a date within 60 days after the date of the distribution. Members of the Designated Beneficiary's family include the Designated Beneficiary's spouse, children and their descendants, stepchildren and their descendants, siblings and their children, stepbrothers and stepsisters, parents and grandparents, stepparents, and spouses of all the foregoing. In addition, family members include first cousins, father-in-law, and mother-in-law.
The $2,000 annual contribution limit to ESAs does not apply to these rollover contributions. For example, an older brother who has $2,000 left in his ESA after he graduates from college can roll over the full $2,000 balance to an ESA for his younger sister who is still in high school without paying any tax on the transfer.

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What happens to the assets remaining in an ESA after the Designated Beneficiary finishes his or her postsecondary education?

There are two options. The amount remaining in the account may be withdrawn for the Designated Beneficiary. The Designated Beneficiary will be subject to both income tax and the additional 10 percent penalty tax on the portion of the amount withdrawn that represents earnings if the Designated Beneficiary does not have any qualified education expenses in the same taxable year he or she makes the withdrawal. Alternatively, if the amount in the designated beneficiary's ESA is withdrawn and rolled over or transferred to another ESA for the benefit of a member of the Designated Beneficiary's family, the amount rolled over or transferred will not be taxable.

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Rather than rolling or transferring the money from one ESA to another, may the Designated Beneficiary of the account be changed from one Designated Beneficiary to another without triggering a tax?

Yes, provided: (1) the terms of the particular trust or custodial account permit a change in the Designated Beneficiaries (each trustee or custodian will control whether options like this one are available in the accounts they offer), and (2) the new Designated Beneficiary is a member of the previous Designated Beneficiary's family and has not attained age 30.

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May the Designated Beneficiary or the Designated Beneficiary's parents claim the Hope Scholarship Credit or Lifetime Learning Credit for the Designated Beneficiary's expenses in a taxable year in which the Designated Beneficiary receives money from an ESA on a tax-free basis?

Yes, an education credit may be claimed in the same year the Designated Beneficiary takes a tax-free distribution from his or her ESA as long as the same expenses are not used for both benefits. Refer to IRS Publication 970 and/or your tax advisor for more guidance.

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What if the Designated Beneficiary earns an academic scholarship and the tuition is waived?

The amount of scholarship money the Designated Beneficiary receives is deducted from the allowable expenses for the Coverdell ESA.
For example, if qualified expenses total $6,000 and the Designated Beneficiary receives a scholarship for $3,000, the Designated Beneficiary can make a qualified withdrawal of $3,000 from the Coverdell ESA.

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When must assets in an ESA be distributed?

ESA assets must be distributed no later than 30 days after the Designated Beneficiary's death or attainment of age 30. (This rule does not apply to special needs beneficiaries.)

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Can the ESA be transferred to another individual?

Yes. If the designated beneficiary) decides not to go to college or leaves school before all the funds are withdrawn, you can roll unused funds into the Coverdell ESA of another family member. The beneficiary of the Coverdell ESA who receives the unused funds must be under the age of 30 (except that the age 30 limit does not apply to a special needs beneficiary).

Family members of the designated beneficiary who are eligible to receive unused funds include (but are not limited to) spouses, siblings, stepsiblings, nieces, nephews, first cousins, parents, aunts, uncles, grandparents, children and grandchildren.

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Do any exceptions apply to the distribution requirement when the Designated Beneficiary dies?

Yes. If the Responsible Individual rolls over or transfers the ESA to a surviving spouse or other eligible family member due to the Designated Beneficiary's death, the ESA retains its status. This means the spouse or other family member may treat the ESA as his or her own until he or she attains age 30. The age limitation does not apply to new Designated Beneficiaries who are special needs beneficiaries. There are no tax consequences due to the transfer. If the ESA agreement allows the designation of a Death Beneficiary and that Death Beneficiary is not an eligible family member, the remaining assets must be distributed within 30 days of the Designated Beneficiary's date of death. ESA assets distributed (that are not rolled over or transferred to another eligible family member) are taxable to the extent they represent earnings distributed from the account.

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ADDITIONAL PROVISIONS

Transfers. ESAs may be moved from one trustee or custodian to an IRA maintained by another trustee or custodian by requesting a direct transfer.

Federal law does not limit the number of transfers you may make during any year. ESA transfers are reportable to the IRS.

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Prohibited Transactions. The ESA may not be engaged in a "prohibited transaction." Prohibited transactions are defined in IRC Section 4975.

Examples include borrowing money from the ESA, selling property to the ESA, receiving unreasonable compensation for managing the ESA or buying property with ESA funds for your personal use. Engaging in a prohibited transaction will most likely result in adverse tax consequences, including disqualification of the ESA.

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Using the ESA as Security for a Loan. If the ESA is pledged as security for a loan, the amount pledged is treated as a distribution and is includable in income and may be subject to the 10 percent premature distribution penalty tax.

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MISCELLANEOUS

Non-forfeitability. Your interest in your ESA is non-forfeitable at all times.

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Investment Restrictions. Money in the ESA may not be used to buy a life insurance policy or invested in collectibles as defined in IRC Section 408(m). However, certain gold, silver and platinum coins, bullion and coins issued under state laws are allowable investments.

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No Commingling. Assets in the ESA may not be combined with other property, except in a common trust fund or common investment fund.

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Tax Filing. The Responsible Individual is responsible for filing the applicable IRS forms to report certain activities, taxable income and/or penalties associated with the ESA.

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IRS Form. This ESA uses the precise language of IRS Form 5305-E or 5305-EA and is therefore treated as approved by the IRS. Additional language has been included as permitted by such form. The IRS approval represents a determination as to form and not to the merits of the account.

IRS FORMS PAGE

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