Coverdell Education Savings Accounts (Education IRAs)
COVERDELL EDUCATION SAVINGS ACCOUNTS (EDUCATION IRAs)
One way to contribute to a child or grandchild’s college education is to contribute to a Coverdell Education Savings Account. Total contributions are limited to $500 per child in 2001, and this limit goes up to $2,000 in 2002 and beyond. In 2001, no contribution may be made to an Education IRA if contributions are also made to a state-sponsored prepaid tuition program on the child's behalf. This restriction will be eliminated beginning in 2002. In 2001, the deadline for making a contribution is December 31st but in 2002 and after, like a regular Individual Retirement Account, the deadline for making contributions to an Coverdell Education Savings Account for each year is April 15th of the following year.
The contributions must be made in cash; no stocks, bonds, or other property is allowed. It can be set up with a brokerage firm or a bank as trustee. There are income limits that make high-income individuals ineligible to make contributions to a Coverdell Education Savings Account. For that reason, in some years the grandparents or aunts and uncles will make the contributions to a Coverdell Education Savings Account for a child instead of the parents.
A Coverdell Education Savings Account is an investment that enables a child to withdraw the funds, including any appreciation, tax-free for his or her educational expenses. Beginning in 2002, expenditures for which tax-free withdrawals are allowed will include items such as computers, uniforms, transportation, and extended day programs in addition to tuition, books, fees, and room and board, from kindergarten on up. The funds also may be withdrawn to purchase tuition credits and certificates, or make contributions to a state-sponsored prepaid tuition program. Perhaps because the child may withdraw the funds tax free, the person who makes the contribution to the Coverdell Education Savings Account does not get a tax deduction for the contribution.
A youngster can transfer the unused balance in his Coverdell Education Savings Accounts to those of a family member such as a brother, sister, niece, nephew, or first cousin, without penalty. But if he decides to spend the money on something else, he will have to pay income tax on part of the fund, plus a 10 percent penalty. Also, transferring the balance of an existing Coverdell Education Savings Account to one that is set up for a person other than the originally intended recipient may trigger gift tax and generation skipping transfer tax issues.
Not everyone can contribute to a Coverdell Education Savings Account. The law excludes taxpayers who are in high income brackets from making contributions. In some instances the law merely restricts the amount of the contribution they can make. Single taxpayers who are at an annual income level of $110,000 or higher and married taxpayers at a combined annual income level of $165,000 or higher are ineligible to make any contribution to a Coverdell Education Savings Account for 2001. This income limit rises in 2002 and thereafter so that married taxpayers who have less than $220,000 of income for 2002 and later will be able to make a contribution to a Coverdell Education Savings Account. No one can contribute to a Coverdell Education Savings Account for a child’s benefit after the child’s 18th birthday unless the child has “special needs”, as determined by IRS regulations.
There is also a limit to the amount of total contributions that can be made to Coverdell Education Savings Accounts for a single child. That amount is $500 per child per year in 2001 and $2000 per child per year in 2002 and later. One or more persons may contribute for the same year to more than one Coverdell Education Savings Account for the same child, so long as the aggregate of all those contributions does not exceed the maximum amount.
If contributions are made improperly or exceed the annual limit, there will be a six percent penalty assessed. This penalty can be avoided if the amount of impermissible or excess contribution is withdrawn from the Education IRA, along with any earnings attributed to it. For improper or excess contributions made for 2001, contributors have until April 15, 2002 to withdraw the amount without incurring a penalty. For improper or excess contributions made for 2002 and thereafter, contributors have until June 1st of the following year to withdraw the amount.
Finally, unlike tuition that is paid directly to a school for the child’s benefit, the amounts contributed to Coverdell Education Savings Accounts are considered gifts that will use up some of the contributor’s annual gift tax exclusion amount for that child for the year. The exclusion amount usually is limited to either $10,000 or $20,000, (or $11,000 and $22,000, respectively, in 2002) depending on the contributor’s marital status.
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