Coverdell Education Savings Accounts: Covering the Basics (page 2)
Coverdell ESAs are savings plans described in Section 530 of the Internal Revenue Code (IRC). They're accounts that Congress created to allow you to save now for future educational expenses, whether primary, secondary, or postsecondary, of a designated beneficiary.
You can invest money in Coverdell accounts in a variety of ways: stocks, bonds, money market accounts, certificates of deposit, and so on, although you may not invest in life insurance policies. And I really mean that you can invest; under the Coverdell rules (and unlike Section 529 rules), if you designate yourself the one responsible for all decisions on this particular account (also known as the responsible adult, who must be the parent or legal guardian of the minor child), you keep control of the money and make all the investment decisions for your child's account. Over the years, the investments will hopefully earn significant income through interest, dividends, and capital gains, until the time that the account is closed.
You pay no income tax on the income when it's earned, and as distributions are made from these accounts to your designated beneficiary for qualified educational expenses, the income portion of the distribution is not taxed, either to you or to your student.
A Coverdell ESA must be opened as such, in writing, and you need to designate a beneficiary when you create it; you aren't allowed to take an already existing account and decide that it's now the Coverdell account for your student. Money that you contribute into the account is held by a trustee or a custodian, which must be a bank, mutual fund company, or any other entity that's approved by the Internal Revenue Service (IRS).
Understanding Coverdell Changes
When these accounts were first introduced in 1997 as Education IRA's, they were limited to $500 a year aggregate contribution per student, and distributions could be used to cover only postsecondary expenses. If you were thinking of making a contribution into any plan, you probably would've chosen a Section 529 plan, which had fewer restrictions and allowed you to maintain some contact with your money. Basically, the old Education IRA was a nonstarter for most people because contribution limits were fairly pathetic, and much better ways to save money for college were available.
In the new world of Coverdell (same code section, different name), the aggregate contribution limit has been raised to $2,000 per year, the definition of "qualifying student" has been hugely expanded, and you may now contribute to both a Coverdell account and a Section 529 plan for the same beneficiary in the same year. With all these factors, plus an increase in the income phaseout limitations present under Coverdells but not 529 plans, these accounts can become useful savings tools for many families.
Knowing Who Owns The Account
No matter who makes contributions into a Coverdell ESA, the IRS considers the designated beneficiary to be the owner of the assets. If you structure the accounts for your children correctly, though, you can remain in control of the assets by naming yourself the responsible adult, or the person in control of the account, when you open the account.
If, when your children turn 18, your philosophy is to turn their finances over to them to help them establish their independence, or if you feel your child at that age is more savvy about money and investments than you'll ever be, you may put your child in control at that time, although you don't have to.
If your inclination is to give your child control of his Coverdell ESA account, think carefully before you do. As long as you remain the responsible adult, you make the decisions regarding distribution; your child may have other ideas about what constitutes appropriate use of the money in the account. Even though there are significant penalties for taking nonqualified distributions from a Coverdell ESA, 18-year-olds aren't known for making decisions based on sound financial reasoning; you have to understand that your child may decide to take the money you've saved for his college and run.
Identifying Qualifying Students
In a major departure from the Section 529 definition of "qualifying students," Coverdell qualifying students consist of almost anyone who's studying anything or who's likely to study anything at a later date. This means that, if your budding Picasso is taking up the fine art of finger painting at her local private kindergarten, you may choose to pay for the tuition there by using distributions from your Coverdell ESA. You can do the same at each step along the way, all the way up to and through college and graduate school. There are some caveats, though, that you need to remember.
Age Limitations At Time Of Contribution
In general, you have 18 years in which you, or anyone else, for that matter, can fund a Coverdell ESA for your child, from his date of birth until the day before his 18th birthday. After that, you're done. No matter how much or how little you've managed to put away for that student, you can't add any more to the account. Any increases from now until the termination of the account will have to come from the earnings off your good investments.
Age Limitations At Time Of Distributions
Coverdell ESAs must be completely distributed by the time your designated beneficiary hits his or her 30th birthday. If money is still left in the account on that date, it must be distributed within 30 days, and any earnings on it will be taxed to the beneficiary, plus whacked with a 10 percent penalty.
If you're fast approaching your beneficiary's 30th birthday and substantial money that you may not want to be giving as a birthday gift remains in the account, you can change the designated beneficiary on the account to a member of the current beneficiary's family, provided, however, that the new beneficiary is under age 30.
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