Continued from - Save for College – part 1:
Saving with Coverdell Education Savings Accounts.
You can contribute up to $2,000 in 2012 to a Coverdell Education Savings account (a Section 530 program formerly known as an Education IRA) for a child under 18. These contributions are not tax deductible, but grow tax-free until withdrawn. Contributions for any year, for example 2012 can be made through the (unextended) due date for the return for that year (April 15, 2013). There is no adjustment for inflation, therefore the $2,000 contribution limit is expected to remain at $2,000 for 2012 and beyond.
Only cash can be contributed to a Coverdell ESA and you cannot contribute to the account after the child reaches his or her 18th birthday.
The beneficiary will not owe tax on the distributions if they are less than a beneficiary’s qualified education expenses at an eligible institution. This benefit applies to higher education expenses as well as to elementary and secondary education expenses.
Anyone can establish and contribute to a Coverdell ESA, including the child and an account may be established for as many children as you wish; however, the amount contributed during the year to each account cannot exceed $2,000. The child need not be a dependent, and in fact does not even need to be related to you. The maximum contribution amount in 2012 for each child is subject to a phase out limitation with a modified AGI between $190,000 and $220,000 for joint filers and $95,000 and $110,000 for single filers.
A 6% excise tax (to be paid by the beneficiary) applies to excess contributions. These are amounts in excess of the applicable contribution limit ($2,000 or phase out amount) and contributions for a year that amounts are contributed to a Qualified Tuition Program for the same child. The 6% tax continues for each year the excess contribution stays in the Coverdell ESA.
The excise tax does not apply if excess contributions made during 2011 (and any earnings on them) are distributed before the first day of the sixth month of the following tax year (June 1, 2012, for a calendar year taxpayer). However, you must include the distributed earnings in gross income for the year in which the excess contribution was made. The excise tax does not apply to any rollover contribution.
The child must be named (designated as beneficiary) in the Coverdell document, but the beneficiary can be changed to another family member, for example, to a sibling where the first beneficiary gets a scholarship or drops out. Funds can also be rolled over tax-free from one child’s account to another child’s account. Funds must be distributed not later than 30 days after the beneficiary’s 30th birthday (or 20 days after the beneficiary’s death if earlier). For “special needs” beneficiaries the age limits (no contributions after age 18, distribution by age 30) don’t apply.
Withdrawals are taxable to the person who gets the money, with these major exceptions: Only the earnings portion is taxable (the contributions come back tax-free). Also, even that part isn’t taxable income, as long as the amount withdrawn doesn’t exceed a child’s “qualified higher education expenses” for that year.
The definition of “qualified higher education expenses” includes room and board and books, as well as tuition. In figuring whether withdrawals exceed qualified expenses, expenses are reduced by certain scholarships and by amounts for which tax credits are allowed. If the amount withdrawn for the year exceeds the education expenses for the year, the excess is partly taxable under a complex formula. A different formula is used if the sum of withdrawals from a Coverdell ESA and from the Qualified Tuition Program exceed education expenses.
As the person who sets up the Coverdell ESA, you may change the beneficiary (the child who will get the funds) or roll the funds over to the account of a new beneficiary, tax-free, if the new beneficiary is a member of your family. But funds you take back (for example, withdrawal in a year when there are no qualified higher education expenses, because the child is not enrolled in higher education) are taxable to you, to the extent of earnings on your contributions, and you will generally have to pay an additional 10% tax on the taxable amount. However, you won’t owe tax on earnings on amounts contributed that are returned to you by June 1 of the year following contribution.
© 2013, Bruce McFarland. All rights reserved.