As part of a series of blogs on education planning, we are covering the various options available to you to make an informed choice when it comes to your family or individual situation.
In this blog, we will cover Coverdell Education Savings accounts.
A Coverdell Education Savings Account (CESA) is a type of trust or custodial account with a designated beneficiary under the age of 18 or a beneficiary with special needs to help provide funding for educational expenses.
These accounts are an attractive option for many because distributions for qualified expenses are tax-free. Non-qualified distributions are partly taxable and subject to penalty. Additionally, a CESA covers the cost of qualified higher education and qualifying elementary and secondary education institutions.
Below we lay out the fundamental aspects and considerations for Coverdell Savings Accounts.
CESA Requirements and Advantages
1. A CESA allows for tax-free growth on contributions.
2. There is no limit to the number of accounts under the beneficiary's name if the total contribution across ALL accounts does not exceed the maximum annual contribution of $2,000.
3. Qualified education expenses include elementary, secondary, and higher education.
4. The account needs to be documented and opened following CESA requirements.
5. The beneficiary receives a tax-free distribution for qualified education expenses.
6. In the event of a divorce, the account can be transferred to a spouse without triggering a taxable event.
7. Individuals can still claim either The American Opportunity Credit or Lifetime Learning Credit in the same year the beneficiary uses a tax-free distribution from CESA. However, you cannot double-dip, meaning you cannot use the tax credit and CESA funds to pay for the same books, fees, etc. Similar rules apply for distribution from CESA and a Qualified Tuition Plan (QTP).
8. There is no minimum number of courses required to claim a tax-free distribution.
9. CESA can be rolled over to another CESA account for the same beneficiary or to another family member in the beneficiary’s family as long as the beneficiary is under the age of 30.
CESA Disadvantages
1. Contributions are not tax-deductible.
2. Only cash contributions are allowed.
3. The maximum contribution is $2,000 per beneficiary per tax year. Be mindful that this includes all contributions from all sources such as parents, guardians, grandparents, and other family members.
4. The account is considered an asset of the parent for financial aid purposes.
5. Any distributions made from the account’s growth that are not related to qualified education expenses are taxed to the beneficiary.
6. All assets have to be distributed to the beneficiary by age 30 unless the beneficiary has special needs.
7. Contributions can only be made if the individual contributing has a Modified Adjusted Gross Income (MAGI) of $110,000 if filing Single ($220,000 for MFJ). To bypass this, a trust or an organization can invest and does not have to follow income limits. MAGI is adjusted gross income (AGI) calculated on an individual's tax return on Form 1040.
8. Any excess contributions of more than $2,000 per year for a single beneficiary may be subject to an additional excise tax of 6%. There is an exception to this rule. We can help you plan for this if you choose to make excess contributions to your CESA. An additional 10% tax may also be imposed if the distribution does not meet certain requirements.
9. Funds cannot be used to invest in life insurance.
CESA investment losses cannot be claimed on your tax return until all funds have been distributed. Once all the funds have been distributed and the net distribution is less than the original contributions, then the loss can be deductible for taxes.
The CESA differs most from Education Savings Bonds and 529 plans in the limits for how much can be contributed per child per year. Additionally, with a CESA, you have more flexibility in the types of assets you can contribute to, as funds can be put into stocks, mutual funds, or bonds.
That gives you an overview of the CESA.
Uncertain if it is the right tax-free education planning option for your family? Contact us, and we will gladly review all the options in detail and help you choose the one that best meets your needs.
Sources
1. https://www.irs.gov/pub/irs-pdf/p970.pdf
2. https://www.irs.gov/taxtopics/tc310