Tax Treatment of Coverdell IRAs

by Jeff Franco

A Coverdell Education Savings Account (ESA), though similar to an IRA, is not subject to the same tax treatment by the IRS. Rather, the Coverdell ESA allows you to make nondeductible cash contributions that provide the beneficiary of your choosing with funds to pay for qualified education expenses. Although you don't receive a tax deduction, the funds earn income tax-free and are potentially nontaxable to the student when he begins taking distributions.

Annual Contribution Limits

As of 2011, the maximum annual contribution you can make to a Coverdell account is $2,000. This annual limitation applies on a per-beneficiary basis. Therefore, if you have three separate accounts with different beneficiaries, you can contribute $2,000 to each account. However, the IRS only allows taxpayers who report a Modified Adjusted Gross Income (MAGI) below certain levels to make these contributions. Your MAGI is equal to the AGI you calculate on your return plus the amount of any foreign earned income exclusion you claim.

Tax-Free to Student

The beneficiary you designate can make withdrawals from the Coverdell account without income tax implications if he uses all of the funds for qualified education expenses. However, any part of the distribution that exceeds the student's adjusted qualified education expenses is potentially taxable. A student's qualified education expenses include the cost of tuition, fees, books, supplies and equipment necessary to enroll at a postsecondary school that is eligible to participate in the federal student aid program, regardless of whether the student applies for federal financial aid or not. Students who use the funds for the same expenses, but to attend an elementary or secondary school, also qualify for tax-free distributions. These students can also include the cost of computers and academic tutoring in qualified expenses.

Calculating Taxable Portion

For purposes of determining whether the student must report any part of a distribution on a tax return, it's necessary to compare the distributions to the student's adjusted qualified education expenses for the year. Adjusted qualified education expenses include all qualified education expenses minus the tax-free scholarships and grants the student uses to pay those expenses. At the end of the tax year, you will receive a Form 1098-Q from the financial institution that manages the Coverdell account. The form will report the portion of the distribution that relates to the original contribution and that which relates to the tax-free earnings. Only the earnings of the portion of your distribution that you use for the excess expenses are taxable income to you.

Other Tax Implications

If you, or the taxpayer who claims you as a dependent, takes the lifetime learning or American opportunity tax credit, you must reduce your qualified education expenses by the expenses you use to calculate the credit; not the credit amount itself. In addition, students must use the funds in the Coverdell account no later than 30 days after their 30th birthday. However, to avoid paying income tax on a closing withdrawal at age 30 when you don't have educational expenses, you can change the account beneficiary to a member of your family who is under 30.

About the Author

Jeff Franco's professional writing career began in 2010. With expertise in federal taxation, law and accounting, he has published articles in various online publications. Franco holds a Master of Business Administration in accounting and a Master of Science in taxation from Fordham University. He also holds a Juris Doctor from Brooklyn Law School.

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