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Pluses and Minuses of Coverdell Accounts: Dealing with the Disadvantages (page 3)

By — John Wiley & Sons, Inc.
Updated on Oct 26, 2010

Limiting The Blow If Your Beneficiary Decides Against Going To College

Despite your high hopes and careful planning, you may be paying into a Coverdell account that your student will never use. What can you do then with all that money?

Probably your best bet is to transfer the account to a new beneficiary. But if you have no one who can step up to the plate and replace him as beneficiary or if you feel like that money belongs to the person, you can just hand it over. The tax consequences of doing so can be fairly dramatic, as shown by Nathan's example when his plan is distributed to him at his 30th birthday in one lump sum, but they don't have to be quite as drastic. Some careful planning and the ability to remove the rose-colored glasses can minimize the tax bite for your designated beneficiary.

You always minimize a tax bill when you spread it out over a number of years, and there are no limitations on the number of years you may make nonqualified distributions from a Coverdell account as long as the designated beneficiary is under age 30. It's as simple as that. When you realize that your beneficiary is not going to further his education, you may want to begin making nonqualified withdrawals immediately.

Although putting money into the hands of someone who's failed to live up to your expectations may cause you to grind your teeth, you really don't have a choice. That money belongs to that beneficiary, and your only control over the matter is when he actually receives it. You need to remember, though, that the longer you keep it in the account, the more income will accumulate there, and the higher the eventual tax bill. The sooner you start paying and the more payments that you make, the lower the total tax bill will be over time.

If, for example, Nathan doesn't receive that full scholarship but instead attends a three-week bartending school (which isn't an eligible educational institution) when he turns 21, the money that his parents have saved in his Coverdell account will need to be distributed to him at some point either before or immediately after his 30th birthday. If all the other factors in the earlier example remain the same, the damage incurred by the lump sum distribution at his 30th birthday remains the same. Suppose, however, that his parents choose to distribute the account to him beginning when he's 18 and make equal distributions of their contributions over the 12 remaining years the account may remain open. In that situation, Nathan's overall tax liability is decreased, even if he pays federal income tax on the accumulated earnings at a 25 percent marginal rate (remember, Nathan is now a bartender and earning reasonable money).

Table 10-2 shows how spreading the account distributions out over time minimize the income taxes and penalties Nathan will pay.

Age

Total Nonqualified Distribution

Contribution Amount

Accumulated Earnings

Federal Income Tax on Earnings at 25%

10% Penalty on Earnings

Total Tax Paid

18

$5,000.00

$3,000.00

$2,000.00

$500.00

$200.00

$700.00 

19

$5,250.00

$3,000.00

$2,250.00

$562.50 

$225.00 

$787.50

20

$5,512.50

$3,000.00

$2,512.50

$628.13 

$251.25 

$879.38 

21

$5,788.13

$3,000.00

$2,788.13

$697.03 

$278.81

$975.84 

22

$6,077.53

$3,000.00

$3,077.53

$769.38 

$307.75

 $1,077.14

23

$6,381.41

$3,000.00

$3,381.41

$845.35

 $338.14

 $1,183.49

24

$6,700.48

$3,000.00

$3,700.48

$925.12 

$370.05

 $1,295.17 

25

$7,035.50

$3,000.00

$4,035.50

$1,008.88 

$403.55 

 $1,412.43

26

$7,387.28

$3,000.00

$4,387.28

$1,096.82 

$438.73

$1,535.55 

27

$7,756.64

$3,000.00

$4,756.64

$1,189.16 

$475.66 

$1,664.82 

28

$8,144.47

$3,000.00

$5,144.47

$1,286.12 

$514.45

$1,800.57

29

$8,551.70

$3,000.00

$5,551.70

$1,387.92 

$555.17 

 $1,943.09

Totals

$79,585.63

$36,000.00

$43,585.63

$10,896.41

$4,358.56

$15,254.97

Table 10-2: Nathan's Federal Income Tax Situation When He Takes Nonqualifying Distributions over 12 Years

Because Nathan's parents have chosen to pay down his Coverdell account over the period of time from when they first realize that Nathan won't need this money for qualified educational expenses until the time that the account needs to be completely distributed, they help him save almost $10,000 in taxes. Paying tax and penalties on the earnings accumulated in a Coverdell account is never the outcome your dreams when you first open the account. If that does happen, however, careful planning can help you minimize the damage, as Table 10-2 shows.

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