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Coverdell Education Savings Account Tax Break Expiring

Posted By Jim On 07/12/2010 @ 7:09 am In Taxes | 11 Comments

The Coverdell Education Savings Account, or Coverdell ESA, is the education version of a Roth IRA. You get to make annual non-deductible contributions, like a Roth IRA, and withdrawals are tax-free if you meet certain requirements. It’s a great benefit for many families because anytime you can have an investment grow tax free, you should try to find a way to take advantage of it.

The Coverdell ESA, once known as the Education IRA, is the only tax advantaged option for primary and secondary education. All other tax benefits apply strictly towards college and beyond. Unfortunately, there are some changes on the horizon for old Coverdell.

How Coverdell ESAs Work

You know the basic idea, so here are the specifics. You will be allowed to contribute up to $2,000 a year with income phaseout limitations based on your modified adjusted gross income (MAGI). For single filers, the phaseout starts at $95,000 and ends at $110,000. For married filers, the phaseout starts at $190,000 and ends at $220,000. Unlike the Roth IRA, there are no income requirements to contribute to a Coverdell ESA [3] so if you are phased out of contributing, you could always gift funds to someone else to contribute into an ESA. Each beneficiary, who mush be under the age of 18 or be a special needs beneficiary, can receive at most $2,000 in total contributions across all Coverdell ESAs each year.

You can withdraw the proceeds tax free if they are put towards eligible educational expenses. Unlike other tax deductions and credits for education, elementary and secondary school expenses qualify. Tuition, fees, books, supplies, and tutoring all qualify as eligible if they are related to the beneficiary and they are enrolled at an elementary or secondary school. For college expenses, the beneficiary must be enrolled at least half time and the qualified education expenses match those of the Hope and Lifetime Learning Credits.

For the purposes of financial aid, an ESA is considered a parent asset. ESAs and 529 plans receive equal treatment in the Federal Methodology [4] for calculating financial and qualified distributions are not considered income.

No double dipping. If you claim an educational expense for the purposes of a Hope or Lifetime Learning credit, you cannot use it for a Coverdell distribution. If you claimed it for use with a Series EE or Series I bond interest exclusion, you cannot use it for a Coverdell distribution.

Finally, when the beneficiary turns 18, they can take full control of the Coverdell ESAs and distributions must be completed by the time they turn 30. You may opt to change the beneficiary at any time. For more information, IRS Publication 970 [5] covers Tax Benefits for Education, including the Coverdell ESA.

Coverdell Tax Breaks Ending 2011

Unfortunately, starting in 2011, any earnings you withdraw will be taxed as ordinary income and subject to a 10% penalty unless they are used for college expenses. In other words, your original contributions are not taxed but the appreciation will be. In addition, the maximum annual contribution will fall from $2,000 to a mere $500.

What can you do if you can’t spend your Coverdell ESA? You can roll the funds into a 529 plan without penalty if both accounts have the same beneficiary. If this is what you intend to do, get your ducks in a row now so you can complete the rollover this year.

It’s only mid-way through the year so you still have some time to find expenses to use it on!

(Photo: stevecadman [6])


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[3] Coverdell ESA: http://www.irs.gov/newsroom/article/0,,id=107636,00.html

[4] Federal Methodology: http://www.petersons.com/common/article.asp?id=1007&path=gr.pfs.advice&sponsor=1

[5] IRS Publication 970: http://www.irs.gov/pub/irs-pdf/p970.pdf

[6] stevecadman: http://www.flickr.com/photos/stevecadman/246302725/sizes/l/

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