Thursday, November 12, 2009

The Costs & Rewards of a College Education

Part 3 - College Funding Options: Coverdell Education Savings Accounts

The Coverdell Education Savings Account is also referred to as an Education IRA, although it is important to note that a Coverdell Education Savings Account is not an IRA.  It allows qualified taxpayers (usually parents and grandparents) to establish and contribute up to $2,000 per year for each designated beneficiary under the age of 18; current tax law prohibits contributions once the designated beneficiary reaches the age of 18.

Contributions are nondeductible but can be invested in any U.S. stock, bond or mutual fund.  A contributor’s income could potentially limit the amount of contributions made in a given year.  To contribute fully in 2009, a person must make no more than $95,000 if filing as a single taxpayer, $190,000 if married filing jointly.  Limited contributions are allowed for single taxpayers earning up to $110,000 and married couples making up to $220,000.  Beyond those higher income levels, a person cannot contribute.  However, there are no requirements that contributions come from earned income.  Therefore, if a parent or grandparent is not eligible to make a contribution due to their income they can simply gift the amount to the child who can then make a contribution into their account.

For members of the military and their families, if you received a military death gratuity or a payment from Servicemember's Group Life Insurance (SGLI) after October 6, 2001, you may roll over all or part of the amount received to one or more Coverdell ESAs for the benefit of members of the beneficiary's family. Such payments are made to an eligible survivor upon the death of a member of the armed forces.  This rollover contribution is subject to the contribution limits discussed earlier. The amount you roll over cannot exceed the total survivor benefits you received, reduced by contributions from these benefits to a Roth IRA or other Coverdell ESAs.  The contribution to a Coverdell ESA from survivor benefits received after June 16, 2008, cannot be made later than 1 year after the date on which you receive the gratuity or SGLI payment. If you received survivor benefits before June 17, 2008, with respect to a death from injury occurring after October 6, 2001, you can contribute to a Coverdell ESA no later than June 17, 2009.  The amount contributed from the survivor benefits is treated as part of your basis (cost) in the Coverdell ESA, and will not be taxed when distributed.  The limit of one rollover per Coverdell ESA during a 12-month period does not apply to a military death gratuity or SGLI payment.

Coordination of contributions should be closely monitored.  The annual exclusion for making gifts to any individual is $13,000 for 2009.  If a parent is making contributions for a child to both a Coverdell Education Savings Account and, say, a state-sponsored 529 savings plan that parent needs to make sure they do not put more than the annual exclusion amount collectively into both plans.  Unlike 529 plans, there is no 5-year averaging allowed for Coverdells.

Withdrawals are tax-free if the money is used for qualified higher education expenses.  One of the main advantages of Coverdell Education Savings Accounts, as compared to other educations savings vehicles such as 529 plans, is that distributions can be used for educational expenses of any grade level; like parochial elementary, private high school or a public college.  The educational expenses that qualify are broken into two categories: Qualified Elementary and Secondary Education Expenses, and Qualified Higher Education Expenses.

Qualified Elementary and Secondary Education Expenses are related to enrollment or attendance at an eligible elementary or secondary school.  To be qualified, some of the expenses must be required or provided by the school.  The following expenses must be incurred by a beneficiary in connection with enrollment or attendance at an eligible elementary or secondary school: tuition and fees, books, supplies, and equipment, academic tutoring, and special needs services for a special needs beneficiary.  Other qualified expenses must be required or provided by an eligible elementary or secondary school in connection with attendance or enrollment at the school:  room and board, uniforms, transportation, and supplementary items and services (including extended day programs).  The purchase of computer technology, equipment, or internet access and related services is also a qualified elementary and secondary education expense if it is to be used by the beneficiary and the beneficiary’s family during any of the years the beneficiary is in elementary or secondary school.

Qualified Higher Education Expenses are expenses related to enrollment at an eligible postsecondary school.  To be qualified, some expenses must be required by the school such as tuition and fees, books, supplies, and equipment and some must be incurred by students who are enrolled at least half-time, such as room and board.  These expenses must be reduced by the amount of tax-free benefits received, such as scholarships, to determine how much can be distributed without incurring a taxable event.

There are a few key limitations of the Coverdell Education Savings Account.  Any balances not used by a child’s 30th birthday must be distributed or transferred to another family member (can include niece and nephew).  If not, the balance will go to the child and will be subject to income tax and a 10% penalty.   Additionally, the $2,000 contribution limit is per beneficiary, regardless of the number of accounts opened for the child.  Any excess contributions are subject to a 6% excise tax penalty.  Excess contributions, and any earnings on the excess contributions, can be withdrawn before May 31st of the following year without incurring the 6% penalty.  The earnings, however, will be subject to income tax.

In the past, distributions could not be used in conjunction with the Hope or Lifetime Credit, which are described in more detail below.  The Internal Revenue Service now allows a distribution from the account in the same year that the Hope or Lifetime Learning Credits are claimed as long as the money is not used to pay for the same expenses.

As with 529 plans, if a parent owns the plan it is considered a parental asset and therefore has a minimal effect on the amount of financial aid available.

Please do not hesitate in contacting me with any questions you may have regarding the Coverdell Education Savings Account.  I welcome any and all comments and suggestions!

Next week, I will discuss the basics of yet a few other college savings options - U.S. Savings Bonds and UTMA/UGMA Savings Accounts.

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