Coverdell Education Savings Accounts: Making Account Contributions

Spelling Out Contribution Limits

Before 2002, contributions into the old Education IRA's were limited to $500 per student per year, subject to some phaseout rules. In addition, if you made a contribution to an Education IRA in a given year for a given student, you couldn't also make a contribution to a Section 529 plan. As a result of these low contribution limits, most people didn't bother to fund these accounts, and even if they did, it probably never amounted to much. The Economic Growth and Tax Relief Reconciliation Act of 2001, which changed Education IRA's to Coverdell ESAs, greatly expanded the number of people who were willing to contribute and the amount that could be given.

Today, although the amount that can be contributed is much greater, there are still contribution limits, and you have to keep track of them. You need to know not only how much you're putting into any one beneficiary's account but also how much other people may be putting into either that account, or other accounts, for the same beneficiary.

As always, the IRS expects you to know or to find out the answers here. Mistakes are your mistakes, and they'll be costly to your student.

Aggregate Annual Contributions, Per Beneficiary

Annual contributions into Coverdell ESAs for the benefit of any person may not currently exceed $2,000 per year. This means that you and everyone you know, all together, may not make contributions of more than $2,000 in any year for any beneficiary.

For example, Harvey and Cynthia have one child for whom they've set up a Coverdell ESA. In 2002, they contributed $2,000 to this account. They plan to do the same in 2003, but much to their surprise, they find that Harvey's brother has put his $500 birthday gift for his nephew into the account in 2003 (he's a pretty generous uncle). In 2003, then, Harvey and Cynthia may put only $1,500 into the Coverdell account they established, in order to not exceed the maximum contribution per beneficiary of $2,000 annually.

As this example shows, your contributions aren't limited only to plans that you set up; you may make payments into any plan established for a particular beneficiary.

Annual Contributions Per Contributor

The $2,000 aggregate contribution limit refers only to the amount that may be given per beneficiary. Code Section 530 doesn't limit the number of beneficiaries into whose plans you may contribute.

For example, Harvey and Cynthia now have four children (they've added a set of triplets). They may establish Coverdell ESAs for each of their children. In each year in which they meet the income phaseout requirements, they may contribute up to $2,000 into an account for each of their children (as long as their children are under age 18), or a total of $8,000 annually ($2,000 x 4). Should Harvey's generous brother decide to contribute his birthday gifts into the kids' Coverdell accounts rather than giving the money to his nieces and nephews outright, the amount that Harvey and Cynthia may contribute will be reduced by the amount of that gift.

Gift Tax and Generation-Skipping Transfer Tax Consequences

Unlike gifts in Section 529 plans, which may be quite large and often trigger Gift and Generation-Skipping Transfer Tax (GSTT) consequences on their own, gifts into Coverdell ESAs will never, by themselves, create a situation where you need to fill out a Form 709. The limit on the size of the annual contribution per beneficiary prohibits this, as $2,000 will never begin to approach the $13,000 annual exclusion amount currently available to every donor for every donee.

However, if you use a Coverdell ESA as part of a savings plan and are taking advantage of other ways to push income and assets to your children, grandchildren, or any other friend or relative, you need to know that a contribution into a Coverdell account constitutes a completed gift, or a gift over which you've given up all right, title, and interest. As such, if your total contributions into a combination of a Coverdell account, a Section 529 plan or plans, trust account(s), and/or outright gifts to or for the benefit of a single person total more than $13,000 in any given year, then you have to file a Form 709, United States Gift (and Generation-Skipping Transfer) Tax return.

When you consider that gifts may come into any of your beneficiaries' accounts from a variety of sources, remember that, for gift tax purposes, the number you need to focus on is the amount you give to each person in any given year, not the total amount from all sources that is given to each person.

Looking At Income Phaseouts For Contributors

Anyone can make a contribution into a Section 529 plan, regardless of how much income he or she earns. This isn't the case for Coverdell ESAs; income really matters here. If you earn too much, you may be dumb out of luck in any given year and may have to wait to make contributions into your students' accounts only in the years in which your income falls below the limits.

The income phaseout range for single taxpayers is $95,000 to $110,000, based on your modified adjusted gross income, described later in this section, and the range for married taxpayers is $190,000 to $220,000, or exactly double that of single taxpayers. Here's how the phaseout system works:

• If you're below the bottom of the phaseout range, you may contribute the full $2,000 per beneficiary.
• If you're within the phaseout range, your contribution will be limited according to a formula.
• If you're above the phaseout range, you may not make any contributions in the current year.

For the purpose of determining whether you may, or may not, contribute, you need to calculate your modified adjusted gross income, which adds the following items to your adjusted gross income from your tax return (from the line labeled "Adjusted Gross Income"):

• Your foreign earned income exclusion
• Your foreign housing exclusion
• If you're a bona fide resident of American Samoa, your excluded income
• Any excluded income from Puerto Rico

After you arrive at your modified adjusted gross income, you then can determine whether you can contribute at all or if your contribution will be limited. If you find that you fall within the phaseout range, you may calculate your limited contribution, using Figure 8-1 as an example.

*Adapted from IRS Publication 970, Tax Benefits for Education, page 33.

Figure 8-1: Worksheet to figure out limited contribution to a Coverdell account.

If you complete the calculation in the worksheet and find that your ability to contribute into a Coverdell account for a given year is limited or not allowed at all, don't despair. Someone else with a lower income may be able to make the contribution instead of you. If that person doesn't have the spare cash lying around, you can make a gift to that person and trust that she'll then make a reciprocal gift right back to your designated beneficiary in his or her Coverdell account. Conversely, you may also decide to increase the amount you're putting into your student's Section 529 plan for that particular year.

Getting rid of excess contributions

Because of the limits on contributions, you've probably already deduced that, when you give more than the maximum allowed, you're going to have your hand slapped. In fact, it's quite a hand slap — the penalty for making excess contributions is a 6 percent excise tax on the overage (contribution amounts plus any earnings attributable to those contributions) for each year that it remains in the account.

Despite your best planning and plotting, excess contributions do happen. You may have put money into your kids' accounts at the beginning of the year and then gone on to earn much more money than you anticipated. Or you could've contributed the maximum amount, unaware that Grandma was also funding an account she had set up for your student. Excess contributions happen for any number of reasons; the important fact to know is that they can be corrected.

Once your student receives his contribution information from the account custodian or trustee on Form 5498 each year, you can determine whether more than the maximum $2,000 has been contributed in a particular year for that child. If it has been, then you have three ways to deal with the problem:

• Withdraw the excess cash
• Pay the 6 percent excise tax
• Absorb the excess contributions in future years by not making additional contributions

Withdrawing The Excess

When you discover that too much money has been put into a Coverdell account or accounts for your child, the easiest solution is to withdraw the excess contribution (plus any earnings that have accrued on that amount) before the due date of the student's tax return. There will be no excise tax on the excess, but the student is responsible for paying the income tax (but no 10 percent penalty) on the income earned for the period of time the extra money stays in his account.

If you've made excess contributions and you choose to withdraw money to fix the problem, the distribution that you take is not only taxed to your beneficiary (to the extent of any earnings) but also paid to the beneficiary. Depending on the size, this excess could represent a considerable chunk of money, money that you may not want to hand over to a child or a teen.

Paying The Excise Tax

Suppose that you fail to notice that you've put too much money into your student's account, or you don't manage to correct the problem in time (before your student's tax return filing deadline). As a result, for the year following the year of the excess contribution and for all subsequent years until the problem is resolved, your beneficiary will have to pay an additional 6 percent excise tax on all excess amounts each year that they remain in the account. At any time along the way, you can fix this by withdrawing the overage from the account; in the year the funds are withdrawn, your student will pay the income tax only on the income earned by the excess.

Absorbing Excess Contributions

Finally, you may find that the problem eventually disappears all by itself. If your designated beneficiary is under age 18, you may choose to stop making contributions into his account, and instead each year assign up to the maximum $2,000 contribution amount (depending on where your income falls in the phaseout rules) from the excess until the excess has disappeared. For example, Susan's Coverdell ESA currently has $6,000 in excess contributions. Because Susan is only 8 years old, her parents, whose combined income falls well below the phaseout amounts, choose to assign $2,000 from the excess in each of the following three years instead of making additional contributions into Susan's account. In the first year, Susan will pay a 6 percent excise tax on the full $6,000. In year two, she'll pay an excise tax only on $4,000; in year three, $2,000; and in year four, when Susan is 10 years old, she'll no longer pay any excise tax. Beginning in the following year, provided her parents continue to earn less than the phaseout amount, they may again begin to contribute a maximum of $2,000 per year.