When you hear about these different types of tax advantaged accounts, it seems like they always have to do with one of three things – retirement, health, or education. Apparently, the federal government is concerned that too many of us in the general population won’t be able to retire, afford medical care, or get a proper education. This article pertains to the latest on this list – education, and specifically goes into an overview of Coverdell education savings accounts (ESA).

Coverdell education savings accounts are trust accounts that inure to the benefit of a designated beneficiary’s educational needs. The account must be established before the beneficiary turns 18 years of age, unless he or she is special needs, in which case the account may be established after the beneficiary is 18.

Since Coverdell accounts are trusts, they must be incepted using an executed trust document, which you can think of as a contract-like document, which outlines the terms of the trust. In that vein, those terms must include several specifically outlined by the IRS. First, the trustee of a Coverdell account must be a bank or other entity approved by the IRS. Second, the trust document must stipulate that any and all contributions must be in cash, made before the designated beneficiary’s eighteenth birthday unless he or she is special needs, and not push total contributions above $2,000 for a given year. Next, no contributions may be invested in life insurance. Cash contributions cannot be combined with other non-similar property, unless it’s within a common trust fund or common investment fund. Finally, the entirety of the account must be distributed no later than within 30 days of the thirtieth birthday of the designated beneficiary, unless the beneficiary is special needs.

To remain non-taxable, the distributions from Coverdell accounts must be used solely for qualified education expenses and only at an eligible educational institution. Qualified education expenses fall into two camps – higher education and elementary and secondary education. Higher education expenses are tuition and fees, books, supplies and equipment, expenses for special needs services, room and board, and the purchase of computers or peripheral equipment. Note that the room and board expense must not be greater than the greater of either the allowance for room and board set by the school or the actual amount charged if the housing is owned or operated by the school itself. The student must also attend the school at least half-time. Shifting gears slightly, qualified elementary and secondary education expenses encompass the same expenses as those of higher education, but with the additions of academic tutoring, uniforms, transportation, and supplementary items and services.

In terms of the type of eligible educational institution, for postsecondary education, this means a public or private (including for-profit) college, university, vocational school, and other institution, which is eligible to participate in a student aid program administered by the U.S. Department of Education. An eligible elementary or secondary school is any public, private, or parochial (religious) elementary, middle, or high school under state law.

The phase out for contributors to Coverdell accounts for single, head of household, and married filing separately filers is between $95,000 and $110,000; for joint filers, it’s between $190,000 and $220,000. This means that if you’re a single filer and you make more than $110,000 you can’t contribute, and the same goes for joint filers whose income is above $220,000. However, corporations and organizations can contribute to a Coverdell account regardless of income level. Furthermore, as was previously stated, in the trust document section, the contributions must be in cash, for a person less than 18, unless disabled, and must be made by the due date of the contributor’s tax return, not including extensions. Additionally, a limit of $2,000 for contributions for each designated beneficiary may be made in any given year, regardless of the number of Coverdell accounts that beneficiary has. So, for example the designated beneficiary can have 10 Coverdell accounts but no more than $2,000 in contributions spanning over all those ten for a given year.  

What’s more, you can rollover amounts distributed from one Coverdell to another for the same designated beneficiary. Also, you can change the designated beneficiary without tax consequences, as long as the new beneficiary is under 30 at the time of the change, or has special needs. This can be accomplished by simply changing the name on the given Coverdell account.

As for distributions, the designated beneficiary can take a distribution whenever he or she needs one. This distribution is tax free if the total amount is less than or equal to the adjusted qualified education expenses. In this context, the modifier “adjusted” intimates that the amount of expense must be reduced by tax free scholarships and grants, veterans’ educational assistance, tax free Pell grants, employer-provided educational assistance, and other tax free educational benefits. However, if a distribution is partially taxable, you figure the taxable amount by multiplying the total distribution by a ratio of basis in the account initially over the value in the account right before distribution. This gives you the basis portion of the distribution. This basis portion of the distribution is then subtracted from the total distribution, giving you the earnings portion of the distribution. Then, you multiply the earnings portion of the distribution by a ratio of qualified education expenses over total distribution, which gives the tax free earnings portion of the distribution. After this, you subtract the tax free earnings portion of the distribution from the entire earnings portion of the distribution to find the taxable earnings on the entire distribution. This taxable amount is reported on Schedule 1, line 8.

Good news! Coverdell accounts are able to be mixed with both education credits and qualified tuition programs. By education credits, I mean the American opportunity credit and lifetime learning credit. You may take a potentially tax free Coverdell distribution in the year that you also take either the American opportunity credit or lifetime learning credit, assuming you don’t double count the same educational expenses for both Coverdell and the education credit you choose. This same general principle is true for qualified tuition programs, meaning that both a Coverdell distribution and qualified tuition distribution may be taken in the same year as long as the combined distributions don’t eclipse the total adjusted qualified education expenses. However, if the combined distributions do surpass the adjusted qualified education expenses, then either one or both of those distributions is at least partially taxable. Finally, when a portion of your Coverdell distribution is taxable, then a 10% additional tax applies. Exceptions to this additional tax occur when the distribution is: a) paid to a beneficiary after death of the designated beneficiary; b) paid as a result of disability of the designated beneficiary; c) included as the result of a tax free scholarship or grant, veterans’ educational assistance, employer provided educational assistance, or other tax free education payments; d) made for the purposes of attending a U.S. military academy; e) included in taxable income due to one of the two education tax credits; and f) made from excess contributions and their earnings before a given date, which is specified by the IRS each year, which for 2020 is June 1.

As a final note, it’s worth mentioning that although all amounts in a Coverdell account must be distributed within 30 days of the designated beneficiary turning 30 years of age, if such designated beneficiary passes away before that age, then the assets of the account must be either distributed to his or her estate or the entire account may be transferred to a surviving spouse or other family member. If transferred, the account still has the same tax status as a Coverdell education savings account but the new designated beneficiary is the spouse or other family member.

For more information on the tax benefits of education see IRS Publication 970.

If you’re having trouble figuring your Coverdell education savings account into your tax mix, or you have any other tax problem or question, don’t hesitate to call Dino Tax Co at (713) 397-4678 or email us at davie@dinotaxco.com. The initial consultation is always free. Also, consider liking us on Facebook: www.facebook.com/dinotaxco.