What is a CESA?
A Coverdell ESA is a trust or custodial account created or organized in the United States only for the purpose of paying the qualified education expenses of the designated beneficiary of the account.
When the account is established, the designated beneficiary must be under age 18 or a special needs beneficiary.
To be treated as a Coverdell ESA, the account must be designated as a Coverdell ESA when it is created.
The document creating and governing the account must be in writing and must satisfy the following requirements.
- The trustee or custodian must be a bank or an entity approved by the IRS.
- The document must provide that the trustee or custodian can only accept a contribution that meets all of the following conditions: a) Is in cash b) Is made before the beneficiary reaches age 18, unless the beneficiary is a special needs beneficiary; and, c) Would not result in total contributions for the year (not including rollover contributions) being more than $2,000.
- Money in the account cannot be invested in life insurance contracts.
- Money in the account cannot be combined with other property except in a common trust fund or common investment fund.
- The balance in the account generally must be distributed within 30 days after the earlier of the following events: a)The beneficiary reaches age 30, unless the beneficiary is a special needs beneficiary; and, b) the beneficiary’s death.
Qualified Education Expenses
Generally, these are expenses required for the enrollment or attendance of the designated beneficiary at an eligible educational institution. For purposes of Coverdell ESAs, the expenses can be either qualified higher education expenses or qualified elementary and secondary education expenses. Eligible educational institutions can include both postsecondary schools and elementary and secondary schools.
This is the individual named in the document creating the trust or custodial account to receive the benefit of the funds in the account.
Eligible Educational Institution
For purposes of Coverdell ESAs, an eligible educational institution can be either an eligible postsecondary school or an eligible elementary or secondary school.
- Eligible postsecondary school
This is any college, university, vocational school, or other postsecondary educational institution eligible to participate in a student aid program administered by the Department of Education. It includes virtually all accredited, public, nonprofit, and proprietary (privately owned profit-making) postsecondary institutions. The educational institution should be able to tell you if it is an eligible educational institution.
- Eligible elementary or secondary school
This is any public, private, or religious school that provides elementary or secondary education (kindergarten through grade 12), as determined under state law.
Qualified Higher Education Expenses
These are expenses related to enrollment or attendance at an eligible postsecondary school. As shown in the following list, to be qualified, some of the expenses must be required by the school and some must be incurred by students who are enrolled at least half-time. Contributions to qualified tuition programs can be qualified education expenses (see the last item in the following list).
- The following expenses must be required for enrollment or attendance of a designated beneficiary at an eligible postsecondary school: a)Tuition and fees b)Books, supplies, and equipment.
- Expenses for special needs services needed by a special needs beneficiary must be incurred in connection with enrollment or attendance at an eligible postsecondary school.
- Expenses for room and board must be incurred by students who are enrolled at least half-time. The expense for room and board qualifies only to the extent that it is not more than the greater of the following two amounts: a)The allowance for room and board, as determined by the school, that was included in the cost of attendance (for federal financial aid purposes) for a particular academic period and living arrangement of the student. b)The actual amount charged if the student is residing in housing owned or operated by the school.
- Any contribution to a qualified tuition program (QTP) must be on behalf of the designated beneficiary of the Coverdell ESA.
A student is enrolled “at least half-time” if he or she is enrolled for at least half the full-time academic workload for the course of study the student is pursuing, as determined under the standards of the school where the student is enrolled.
Qualified Elem. & Secondary Education Expenses
These are expenses related to enrollment or attendance at an eligible elementary or secondary school. As shown in the following list, to be qualified, some of the expenses must be required or provided by the school. There are special rules for computer-related expenses.
- The following expenses must be incurred by a designated beneficiary in connection with enrollment or attendance at an eligible elementary or secondary school: a) Tuition and fees. b) Books, supplies, and equipment. c) Academic tutoring. d)Special needs services for a special needs beneficiary.
- The following expenses must be required or provided by an eligible elementary or secondary school in connection with attendance or enrollment at the school: a) Room and board. b) Uniforms. c) Transportation. d) Supplementary items and services (including extended day programs).
- The purchase of computer technology, equipment, or Internet access and related services is a qualified elementary and secondary education expense if it is to be used by the beneficiary and the beneficiary’s family during any of the years the beneficiary is in elementary or secondary school. (This does not include expenses for computer software designed for sports, games, or hobbies unless the software is predominantly educational in nature.)
Any individual (including the designated beneficiary) can contribute to a Coverdell ESA if the individual’s modified adjusted gross income (MAGI) (defined later under Contribution Limits) for the year is less than $110,000, for individuals filing joint returns that amount is $220,000, although the individual contributing to the CESA does not have to have earned income. If a parent cannot make a contribution to a CESA because of AGI limitations, they can gift $2,000 to the child, and the child can then establish a CESA with the gifted funds.
Organizations, such as corporations and trusts, can also contribute to Coverdell ESAs. There is no requirement that an organization’s income be below a certain level.
Contributions must meet all of the following requirements:
- They must be in cash.
- They cannot be made after the beneficiary reaches age 18, unless the beneficiary is a special needs beneficiary, and
- They must be made by the due date of the contributor’s tax return (not including extensions).
Contributions can be made to one or several Coverdell ESAs for the same designated beneficiary provided that the total contributions are not more than the contribution limits (defined later) for a year.
Contributions to a Coverdell ESA are considered a completed gift and are, therefore, eligible for the $14,000 annual gift tax exclusion. Contributions can be set up to be treated as being gifted over five years with the five year pro-rata allocation of amounts up to $65,000.
If a person other than a spouse acquires the original beneficiary’s interest, the CESA is deemed to terminate at death and the account balance must be included in the original beneficiary’s income in the year of the death.
Contributions to a CESA are treated as completed gifts of a present interest; contributions are eligible for the annual gift tax exclusion and are excludable for purposes of the generation-skipping transfer tax.
Trustees are required to report to both the IRS and the beneficiary on contribution amounts, distribution amounts, and other matters.
There are two yearly limits:
1. One on the total amount that can be contributed for each designated beneficiary in any year, and
2. One on the amount that any individual can contribute for any one designated beneficiary for a year.
Limit for Each Designated Beneficiary
The total of all contributions to all Coverdell ESAs set up for the benefit of any one designated beneficiary cannot be more than $2,000. This includes contributions (other than rollovers) to all the beneficiary’s Coverdell ESAs from all sources. Rollovers are discussed under Rollovers and Other Transfers, later.
Example: When Maria Luna was born in 2010, three separate Coverdell ESAs were set up for her, one by her parents, one by her grandfather, and one by her aunt. In 2017, the total of all contributions to Maria’s three Coverdell ESAs cannot be more than $2,000. For example, if her grandfather contributed $2,000 to one of her Coverdell ESAs, no one else could contribute to any of her three accounts. Or, if her parents contributed $1,000 and her aunt $600, her grandfather or someone else could contribute no more than $400. These contributions could be put into any of Maria’s Coverdell ESA accounts.
Limit for Each Contributor
Generally, you can contribute up to $2,000 for each designated beneficiary. This is the most you can contribute for the benefit of any one beneficiary for the year, regardless of the number of Coverdell ESAs set up for each beneficiary.
Example: The facts are the same as in the previous example except that Maria Luna’s older brother, Edgar, also has a Coverdell ESA. If their grandfather contributed $2,000 to Maria’s Coverdell ESA in 2017, he could also contribute $2,000 to Edgar’s Coverdell ESA.
Your contribution limit may be reduced. If your modified adjusted gross income (MAGI) (defined below) is between $95,000 and $110,000 (between $190,000 and $220,000 if filing a joint return), the $2,000 limit for each designated beneficiary is gradually reduced. If your MAGI is $110,000 or more ($220,000 or more if filing a joint return), you cannot contribute to anyone’s Coverdell ESA.
Modified Adjusted Gross Income (MAGI)
For most taxpayers, MAGI is adjusted gross income (AGI) as figured on their federal income tax return.
MAGI When Using Form 1040A
If you file form 1040A, your MAGI is the AGI on line 21 of that form.
MAGI When Using Form 1040
If you file Form 1040, your MAGI is the AGI on line 37 of that form, modified by adding back any:
1. Foreign earned income exclusion,
2. Foreign housing education,
3. Exclusion of income for bona fide residents of American Samoa, and
4. Exclusion of income from Puerto Rico.
Additional Tax on Excess Contributions
The beneficiary must pay a 6% excise tax each year on excess contributions that are in a Coverdell ESA at the end of the year.
Excess contributions are the total of the following two amounts:
- Contributions to any designated beneficiary’s Coverdell ESA for the year that are more than $2,000 (or, if less, the total of each contributor’s limit for the year, as discussed earlier).
- Excess contributions for the preceding year, reduced by the total of the following two amounts: a)Distributions (other than those rolled over as discussed later) during the year, and b)The contribution limit for the current year minus the amount contributed for the current year.
The excise tax does not apply if excess contributions made during 2017 (and any earnings on them) are distributed before the first day of the sixth month of the following tax year (June 1, 2018, for a calendar year taxpayer).
However, the taxpayer must include the distributed earnings in gross income for the year in which the excess contribution was made. They should receive Form 1099-Q, Payments From Qualified Education Programs (Under Sections 529 and 530), from each institution from which excess contributions were distributed. Box 2 of that form will show the amount of earnings on their excess contributions. Enter the amount of earnings on line 21 of Form 1040. For more information, see Taxable Distributions, later.
The excise tax does not apply to any rollover contribution.
Rollovers & Transfers
Assets can be rolled over from one Coverdell ESA to another. The designated beneficiary can be changed or the beneficiary’s interest can be transferred to a spouse or former spouse because of divorce.
Any amount distributed from a Coverdell ESA and rolled over to another Coverdell ESA for the benefit of the same beneficiary or a member of the beneficiary’s family (including the beneficiary’s spouse) who is under age 30 is not taxable. However, tax-free rollovers are only permitted once in any 12-month period. An amount is rolled over if it is paid to another Coverdell ESA within 60 days after the date of the distribution.
Members of the Beneficiary’s Family
For these purposes, the beneficiary’s family includes the beneficiary’s spouse and the following other relatives of the beneficiary:
- Son or daughter or descendant of son or daughter
- Stepson or stepdaughter
- Brother, sister, stepbrother, or stepsister
- Father or mother or ancestor of either
- Stepfather or stepmother
- Son or daughter of a brother or sister
- Brother or sister of father or mother
- Son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, or sister-in-law
- The spouse of any individual listed above
- First cousin
Rollovers from a Coverdell ESA to a QTP should be set up in the name of the student, not the name of the parent.
Changing the Designated Beneficiary
The designated beneficiary can be changed to a member of the beneficiary’s family. There are no tax consequences if, at any time of the change, the new beneficiary is under age 30.
Transfer Because Of Divorce
If a spouse or former spouse receives a Coverdell ESA under a divorce or separation instrument, it is not a taxable transfer. After the transfer, the spouse or former spouse treats the Coverdell ESA as his or her own.
The designated beneficiary of a Coverdell ESA can take a distribution at any time. According to Coverdell ESA standards of distribution, a student convicted of a federal or state drug felony is still an eligible student. Whether the distributions are tax free depends, in part, on whether the distributions are equal to or less than the amount of adjusted qualified education expenses that the beneficiary has in the same year.
Adjusted Qualified Education Expenses
To determine if total distributions for the year are more than the amount of qualified education expenses, reduce total qualified education expenses by any tax-free educational assistance. Tax-free educational assistance includes:
- The tax-free part of scholarships and fellowships
- Veteran’s educational assistance
- Pell grants
- Employer-provided educational assistance, and
- Any other nontaxable (tax-free) payments (other than gifts or inheritances) received as educational assistance.
The amount you get by subtracting tax-free educational assistance from your total qualified educational expenses is your adjusted qualified education expenses.
Since contributions to Coverdell ESAs are generally treated as gifts, distributions from these can only be made to beneficiaries, not to the contributor.
Financial Aid Treatment
Coverdell ESAs are regarded as assets of the parent if the parent is the owner of the account, rather than the student, and thereby displace a smaller amount of financial aid.
Distributions from Coverdell ESAs that are not subject to federal income tax are not counted as parent or student income in the determination of federal financial aid eligibility. Distributions for qualified educational expenses therefore do not reduce financial aid eligibility.
Generally, distributions are tax-free if they are not more than the beneficiary’s adjusted education expenses for the year.
If a distribution from a Coverdell ESA is in excess of the qualified education expenses, the distribution is then taxable and subject to a 10% penalty. If the Coverdell ESA distributions are taxable, because the distribution does not meet the criteria for tax-free status, they are taxed similar to annuity rules.
A portion of the distributions is generally taxable to the beneficiary if the distributions are more than the beneficiary’s adjusted education expenses for the year.
This is the part of the total distribution that is more than the beneficiary’s adjusted education expenses for the year.
Earnings and Basis
The taxpayer will receive a Form 1099-Q, for each of the Coverdell ESAs from which money was distributed. The amount of their gross distribution will be shown in box 1, instead of dividing the gross distribution between the earnings (box 2) and the basis (already-taxed amount) (box 3), the payer or trustee may report the fair market value (account balance) of the Coverdell as of December 31st of the tax year. This will be shown in the blank box below boxes 5 and 6.
Coordinating With American Opportunity and Lifetime Learning Credits
The American Opportunity or Lifetime Learning credit can be claimed in the same year the beneficiary takes a tax-free distribution from a Coverdell ESA, as long as the same expenses are not used for both benefits. This means the beneficiary must reduce qualified education expenses by tax-free educational assistance, and then further reduce them by any expenses taken into account in determining a American Opportunity or Lifetime Learning credit.
Coordination With Qualified Tuition Program (QTP) Distributions
If a designated beneficiary receives distributions from both a Coverdell ESA and a QTP in the same year, and the total distribution is more than the beneficiary’s adjusted qualified higher education expenses, those expenses must be allocated between the distribution from the Coverdell ESA and the distribution from the QTP before figuring how much of each distribution is taxable.
Losses on Coverdell ESA Investments
If the taxpayer has a loss on their investment in a Coverdell ESA, they may be able to take the loss on their income tax return. They can take the loss only when all amounts from that account have been distributed and the total distributions are less than the un-recovered basis. The basis is the total amount of contributions to that Coverdell ESA. They claim the loss as a miscellaneous itemized deduction on line 22 of Schedule A (Form 1040), subject to the 2%-of-adjusted-gross-income limit.
Additional Tax on Taxable Distributions
Generally, if the taxpayer receives a taxable distribution, they also must pay a 10% additional tax on the amount included in income.
The 10% additional tax does not apply to distributions:
- Paid to a beneficiary (or to the estate of the designated beneficiary) on or after the death of the designated beneficiary.
- Made because the designated beneficiary is disabled. A person is considered to be disabled if he or she shows proof that he or she cannot do any substantial gainful activity because of his or her physical or mental condition. A physician must determine that his or her condition can be expected to result in death or to be of long-continued and indefinite duration.
- Included in income because the designated beneficiary received: a) A tax-free scholarship or fellowship b) Veteran’s educational assistance c) Employer-provided educational assistance, or d) Any other nontaxable (tax-free) payments (other than gifts or inheritances) received as educational assistance.
- Made on account of the attendance of the designated beneficiary at a U.S. military academy (such as West Point). This exception applies only to the extent that the amount of the distribution does not exceed the costs of advanced education (as defined in title 10 of the U.S. Code) attributable to such attendance.
- Included in income only because the qualified education expenses were taken into account in determining the American Opportunity or Lifetime Learning credit.
- Made before June 1, 2014, of an excess 2013 contribution (and any earnings on it). The distributed earnings must be included in gross income for the year in which the excess contribution was made.
Exception (3) applies only to the extent the distribution is not more than the scholarship, allowance, or payment.
When Assets Must be Distributed
Any assets remaining in a Coverdell ESA must be distributed when either one of the following two events occurs:
- The designated beneficiary reaches age 30. In this case, the remaining assets must be distributed within 30 days after the beneficiary reaches age 30. However, this rule does not apply if the beneficiary is a special needs beneficiary.
- The designated beneficiary dies before reaching age 30. In this case, the remaining assets must generally be distributed within 30 days after the date of death.
If a Coverdell ESA is terminated, without distributing all of the funds in the account, the balance in the account is subject to taxation and a 10% penalty.
Exceptions for Transfer to Surviving Spouse or Family Member
If a Coverdell ESA is transferred to a surviving spouse or other family member as the result of the death of the designated beneficiary, the Coverdell ESA retains its status. This means the spouse or other family member can treat the Coverdell ESA as his or her own and does not need to withdraw the assets until he or she reaches age 30. This age limit does not apply if the new beneficiary is a special needs beneficiary. There are no tax consequences as a result of the transfer.
When a total distribution is made because the designated beneficiary either reached age 30 or died, the earnings that accumulated tax-free in the account must be included in taxable income.
You determine these earnings as shown in the following two steps.
- Multiply the amount distributed by a fraction. The numerator is the basis (contributions not previously distributed) at the end of 2017 plus total contributions for 2017 and the denominator is the balance in the account at the end of 2017 plus the amount distributed during 2017.
- Subtract the amount figured in (1) from the total amount distributed during 2017. The result is the amount of earnings included in the distribution.
The beneficiary or other person receiving the distribution must report this amount on Form 1040, line 21, listing the type and amount of income on the dotted line.