Coverdell accounts are education trusts that allow funds to be put away for a child’s education. Tax on earnings from these accounts is deferred until the funds are withdrawn, and if used for qualified education purposes, the entire withdrawal can be tax-free.These accounts have seen limited use, due in part to small dollar amounts that can be deposited and many limitations imposed both on the contributor and beneficiary of the accounts.
The annual contribution is limited to $2,000 for each beneficiary. Therefore, contributors must be careful that their combined contributions do not exceed the annual limitation. The contribution is further limited for higher income taxpayers. The contribution limit begins to phase out when the taxpayer’s Adjusted Gross Income (AGI) exceeds $95,000 and is fully phased-out when it reaches $110,000. The phase out range for married taxpayers filing jointly is $190,000 to $220,000.
The qualified use of these funds includes kindergarten through post-secondary (college) education expenses. Education credits (Hope/American Opportunity and Lifetime) and tax-free Coverdell withdrawals are allowed in the same year, provided that they are for different qualified expenses.
Example: A single taxpayer establishes a Coverdell Account for a grandson. By the time the grandson reached 18, the taxpayer had contributed $4,500 to the account. Assuming the account earned $1,500 interest, the total account value will be $6,000. When the grandson enters college, he withdraws the entire account balance and uses $4,000 of the funds for tuition and $2,000 for non-qualified expenses. Since some of the fund’s use is non-qualified, a pro-rata share of the earnings must be reported as income by the grandson – in this case $500 is taxable ($1,500 x $2,000/$6,000). In addition to the regular tax, the grandson will also be assessed a 10% tax penalty on the taxable portion.
Each beneficiary under the age of 18 is allowed to have an amount up to the annual limit deposited into their Coverdell Account each year. The contributions made by the contributing taxpayer are nondeductible and care should be exercised so that the combined total of contributions does not exceed the annual contribution limit for the year. This is especially important when more than one individual is making contributions and not sharing that information with others. To escape penalty, any excess contributions must be withdrawn before the sixth month, usually June 1, of the year following the year in which the contribution was made, and the beneficiary must include the distributed earnings in gross income for the year in which the contribution was made.
Contributions to Coverdell Accounts can be delayed to as late as the due date of the contributor’s tax return (generally April 15) allowing them the opportunity to determine if their AGI is within limits so they can make the contribution.
Coverdell or Section 529 Plan – Frequently, the question arises: is it better to contribute to a Coverdell Account or to a Section 529 Plan? Generally, unless the contribution is limited by the AGI phase-out, the Coverdell Account provides more advantages than the Section 529 plans. Here are the strategic differences:
• Coverdell funds can be used for kindergarten and up, while Section 529 plans only apply to post-secondary education.
• Coverdell accounts lack control, since the beneficiaries actually own the accounts and can raid them for other than education purposes once they reach maturity.
• The advantages of a Section 529 plan are control retention by the contributor, larger contributions permitted, and no AGI phase-out limiting contributions.
Strategy – Other than lack of control, it may be to a taxpayer’s advantage to place the first $2,000 contributed toward a student’s education fund in a Coverdell and then any additional amount can be set aside in a Section 529 plan.
Additional rules apply for dealing with rollovers, mandatory distributions, changes in designated beneficiaries, death of taxpayer or beneficiary, and unauthorized use of distributions. Please call this office for additional information.