Many readers said they appreciated the heads-up on Coverdell ESAs, saying they had never heard of them! This despite the fact that most had children who had attended college, were in college or nearly were!
So I think it's time these ESAs were explained a little further.
Contributions to a Coverdale ESA are made with after-tax dollars, so you are not permitted to claim an income tax deduction for your contributions. This means that any portion of future withdrawals that represent your contributions will come out tax-free even if the earnings portion is taxable. You only pay the piper once.
Your child can receive tax-free withdrawals in any year, but only to the extent that he or she incurs qualified higher education expenses (QHEE). If your child withdraws more than the amount of QHEE, then the earnings portion of that excess is subject to income tax and an additional 10% penalty tax.
If you also take withdrawals from a 529 plan in the same year for the same student, you will need to allocate the available QHEE between the accounts. Through 2010, tax-free withdrawals can also be taken from an ESA to pay for certain elementary and secondary school expenses. This includes tuition, fees, tutoring, books, supplies, and equipment incurred in connection with school (grades K through 12). It also includes any room and board, uniforms, transportation and supplementary items which are required or provided by the school. You can even use it for the purchase of computer technology or equipment, or Internet access.
Here's a "watch-out" though. Qualified higher education expenses must be reduced by any other tax-free benefits received, such as scholarships and benefits under a qualifying employer-provided educational assistance program.
Eligible institutions are almost any college, university, vocational school, or other post secondary educational institution eligible to participate in student aid programs administered by the Department of Education.
In any year in which a withdrawal is taken from the ESA (assuming it is not the correction of an excess contribution), your child will receive a Form 1099-Q and will need to determine how much, if any, of the withdrawal is included in taxable income. The instructions for making this computation are contained in IRS Publication 970.
The ESA must be fully withdrawn by the time the beneficiary reaches age 30. If it is not, the remaining amount will be paid out within 30 days subject to tax on the earnings and the additional 10% penalty tax.
The additional 10% tax will not apply to withdrawals made due to the beneficiary’s death or disability, or to the extent that the beneficiary receives a tax-free scholarship. Also, it will not apply if the withdrawal is taxable only because qualified expenses were adjusted with the Hope or Lifetime Learning credit, nor will it apply to a withdrawal that is a return of an excess contribution.
Your contribution is treated as a gift from you to the beneficiary. It qualifies for the annual $13,000 gift tax exclusion.
You can even change the beneficiary on the account to another family member if your child decides not to attend college. The "responsible individual" on the account can change the beneficiary at any time to another "qualifying family member" who has not yet attained the age of 30. A qualifying family member is the beneficiary’s child, grandchild, stepchild, brother, sister, stepbrother, stepsister, nephew, niece, father, mother, grandfather, grandmother, stepfather, stepmother, uncles, aunt, first cousin, son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, or sister-in-law. The spouse of any of these relations (except for a cousin) is also a qualifying family member. The beneficiary’s interest can also be transferred tax-free to a spouse or former spouse because of divorce. The new beneficiary must be under age 30 at the time of rollover.
All in all, a wonderful tool for college savings! Again, see your advisor or tax professional for more details on this program.
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