Subject: Education Savings Plans - Coverdell

Last-Revised: 25 Jan 2003
Contributed-By: Chris Lott (contact me)

A Coverdell Education Savings Account (ESA), formerly known as an Education IRA, is a vehicle that assists with saving for education expenses. This article describes the provisions of the US tax code for educational IRAs as of mid 2001, including the changes made by the Economic Recovery and Tax Relief Reconciliation Act of 2001.

Funds in an ESA can be used to pay for elementary and secondary education expenses, college or university expenses, private school tuition, etc. I am told that the educational institution must be accredited (which in this case means the school can participate in various financial aid programs), but it does not have to be in the United States. In other words, it appears that it's legal to pay tuition at a foreign school using funds from an ESA as long as the school is accredited.

An ESA may be established for any person who is under 18 years of age. Contributions to this account are limited to $2,000 in 2002. Once the beneficiary reaches 18, then no further funds may be contributed. Annual contributions must be made by April 15th of the following year (previously they had to be made by December 31st of the same year).

Although anyone may contribute to a minor's ESA, contributions are not tax deductible, and further, contributions may only be made by taxpayers who fall under the limits for adjusted gross income. As with many provisions in the tax code, the limits are phased; the ranges are 95-110K for single filers and 150-160K for joint filers.

The major benefit of this savings vehicle is that the funds grow free of all taxes. Distributions that are taken for the purpose of paying qualified educational expenses are not subject to tax, thus saving the beneficiary of paying tax on the fund's growth. Distributions that are used for anything other than qualified educational expenses are treated as taxable income and further are subject to a 10% penalty, unless a permitted exception applies.

If the beneficiary reaches age 30 and there are still funds in his or her ESA, they must either be distributed (incurring tax and penalties) or rolled over to benefit another family member.

On a related note, changes made in 1997 to the tax code also permit withdrawals of funds from both traditional IRAs and Roth IRAs for paying qualified educational expenses. Basically, the change established an exception so you can avoid the 10% penalty on distributions taken before age 59 1/2 if they are for educational expenses.

It is possible to roll over funds from an ESA to a (new as of 2002) 529 plan. A roll-over from an ESA plan to a 529 plan is free of tax and penalty as it is completed within 60 days and the account beneficiary is the same.

The rules for ESAs changed in mid 2001 in the following ways:

  • The contribution limit rises from $500 to $2,000 in 2002.
  • Starting in 2002, funds can be used to pay for elementary and secondary education, not just college/university, including private schools.
  • Income limits on those who can fund an ESA rise: married filers will be limited starting at $190,000 starting in 2002.

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