While taxpayers have focused lately on the benefits of IRC section 529 qualified tuition plans (QTPs), Coverdell Education Savings Accounts (ESAs) offer an attractive alternative. A taxpayer can establish an IRC section 530 ESA (formerly known as an Education IRA) for a designated beneficiary attending elementary or secondary school (K-12) by creating a trust to pay his or her qualified education expenses (QEEs). Under IRC section 529(e)(3), QEEs are tuition, room and board, fees, tutoring, services for special-needs students, books, supplies, computer hardware and software (including Web access), uniforms and transportation.
Income limits and age requirements apply to ESA contributions. Under IRC section 530(b)(1)(A)(ii), a donee must be under age 18 when the donor makes the contributions. By age 30 the beneficiary needs to withdraw all the funds invested, according to IRC section 530(b)(1)(E). If the account is not fully depleted by then, the funds can be transferred to another beneficiary tax-free, if certain rules are met.
The maximum contribution per beneficiary decreases when the donor’s adjusted gross income rises to between $95,000 and $110,000 ($190,000 and $220,000 if filing jointly). Contributors must make account deposits in cash by the filing date of their original income tax return (without extensions); the IRS deems such a contribution to have been made by the end of the preceding tax year.
The maximum amount a donor can contribute annually is $2,000 per qualifying designated beneficiary. While there is no limit to the number of accounts that taxpayers can create for each beneficiary, multiple ESAs with combined contributions exceeding $2,000 trigger a 6% excise tax to the account owner (ultimately, the beneficiary) under IRC section 4973(a)(4). A donor must include in income any earnings on excess funds.
Taxpayers make contributions with nondeductible aftertax dollars, so beneficiary withdrawals of principal contributions are tax-free. A beneficiary may withdraw fund earnings tax-free if the amounts do not exceed the QEEs incurred that year. Excess withdrawals that represent the tax-free accumulation of income are subject to income tax. An additional 10% tax applies to the portion of a withdrawal that must be included in income, unless an exception is met.
Contributions to an ESA are eligible for the $11,000 annual gift tax exclusion.
USING BOTH ESAs AND QTPs
A beneficiary can withdraw from both a QTP and an ESA as long as the total withdrawn does not exceed the QEEs incurred that year. When there are excess withdrawals from both types of accounts, he or she must allocate the QEEs between the two accounts to compute the taxable amounts.
Before 2002, if students could claim either the Hope or Lifetime Learning Credit, they had to waive the tax-free treatment of withdrawals from an ESA. Now, when they benefit from claiming either of such credits in the same tax year they make withdrawals, no waiver is needed. However, they cannot use expenses pertaining to either credit when figuring nontaxable ESA withdrawals.
For more information, see The Tax Clinic, edited by Pamela Packard, in the May 2003 issue of The Tax Adviser.
—Lesli Laffie, editor
The Tax Adviser
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