Coverdell Education Savings Accounts: Covering the Basics (page 3)

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

Qualified Expenses For Higher Education

When your student reaches the halls of higher learning (or any other school after he's completed high school), the rules regarding what constitutes a qualified expense for the purposes of Coverdell distributions change. The higher education rules fall in line with those for Section 529 plans, which makes sense. The 2001 tax law changes focused on adding primary and secondary education; it pretty much left alone what was already in place regarding postsecondary education.

In general, the following lists constitutes qualifying educational expenses for postsecondary education payable by tax-free distributions from Coverdell accounts:

  • Tuition and mandatory fees at eligible educational institutions: For a school to qualify, it needs to be able to participate (but doesn't have to if it chooses not to) in federal financial aid programs administered by the Department of Education.
  • Required books, supplies, and equipment: The books on the lengthy list that every professor hands out on the first day of class, laboratory equipment, and any required computer equipment (including peripherals) qualify. Your child's cell phone, which you may require for your peace of mind, does not.
  • Room and board expenses: These expenses are qualified only if
    • They're paid directly to the school itself and your student is attending class at least half time or
    • They don't exceed the amount the school budgets for these expenses, provided your designated beneficiary is at least a half-time student.
If the room and board fees that you pay directly to the school exceed the amount the school budgets for this expense, that's okay. You can still pay the full amount by using a qualified distribution from a Coverdell plan. It's only for that off-campus housing (including fraternities and sororities) that you need to be careful.
  • Contributions into Section 529 Plans: The rules here are fairly straightforward and fairly stringent. If you take a distribution from a Coverdell ESA and contribute it into a 529 plan, the 529 plan needs to be for the same student. After this designation is made, you can't change it; the student was the owner of the funds under Coverdell, so the student needs to remain the beneficiary of the funds under Section 529.
  • Expenses for special-needs services that are required for special-needs students: Once again, the regulations in this area haven't been finalized, so use your common sense. Don't include orthopedic shoes for your flat-footed student, or contact lenses. It's a safe bet that these aren't covered under the regulations.

    The one rule that is apparent is that any services that are paid for by using a distribution from a Coverdell ESA needs to be required by an eligible educational institution.

Many qualified expenses for elementary or secondary school aren't qualified after your student graduates from high school. When you send your student off to college, don't try to pay for that new computer and peripherals from your Coverdell ESA unless the school requires it as a part of the course. You also won't be able to pay for any after-school programming, transportation, uniforms, or academic tutoring for your postsecondary beneficiary with Coverdell funds unless you also want your student to pay income tax and a penalty on the income portion of the distribution.

Following Investing Rules And Regulations

Coverdell ESAs generally follow the same investment rules and regulations as both traditional and Roth IRA accounts. Unlike 529 plans, there's an awful lot that's allowed, and not much that's prohibited. Still, to keep everything kosher, you need to know what you can't do and ways you can't invest.

  • Your contributions need to be made in cash or cash equivalent.
  • You may not purchase collectibles or life insurance with the money in your Coverdell ESA. You're prohibited from buying insurance policies, artwork, household furnishings, antiques, metals, gems, stamps, or certain coins with that money, no matter how fine an investment it may appear to you. Specially minted U.S. gold and silver bullion coins and certain state-issued coins may be permitted. In addition, platinum coins and certain gold, silver, platinum, or palladium bullion are also allowed. If you're interested in making this sort of investment with Coverdell funds, check Internal Revenue Code Section. 408(m)(3) to make sure that the coins or bullion you have in mind qualify.
  • You may not commingle Coverdell account funds with any other funds. Your Coverdell account needs to be set up and accounted for completely separately from any of your other assets. The custodian or trustee, however, has the ability to commingle the money in your Coverdell account with money in other Coverdell accounts, creating what's known as a "Common Trust Fund" or a "Common Investment Fund." These funds work to your advantage because they allow the custodian or trustee to buy investments in larger pieces (which is less costly overall) and then split the pieces among all the accounts that contributed to the purchase.
  • You may not pledge the value of a Coverdell ESA as collateral for any sort of loan. Not only are loans to you and your designated beneficiary prohibited, but so too are margin accounts, or brokerage accounts that allow you to borrow against the value of your stocks in order to either buy more stocks or take cash out of the account.
  • You may not take a loan from a Coverdell ESA, nor may your designated beneficiary. The money that's in the account stays in the account until it's time to make distributions to your beneficiary. Any money that comes out may only come out as a distribution. After it's removed from the account, it may not be returned or repaid later.
  • You may not pay yourself or anyone else for managing your student's Coverdell ESA by using funds from the account. The only fees that may be charged against the account are the custodian's or trustee's. If you need to hire an investment advisor to help you select investments, you need to pay his fee out of your funds, not the account's.
  • You may not sell or lease your property or your beneficiary's property to a Coverdell account, nor may you make any other sort of asset exchange. The only thing that goes into the account is cash, and the only thing that should ever come out is cash, in the form of distributions to your beneficiary. Any other transaction is prohibited.

The custodian or trustee you choose to manage your Coverdell ESA may have other prohibitions in place. You may not be allowed to invest in real estate, for example, or trade in anything more complicated than ordinary stocks and bonds (as opposed to options, puts, calls, or the like). The custodian may also limit you to a certain group of mutual funds or their own certificates of deposit. Investigate what limitations the custodian has in place before you open your account, and make sure that you can live within those rules.

If you goof and make a prohibited transaction under Section 530, you and your beneficiary are out of luck. The entire account will lose its tax exemption or deferral on the day of the prohibited transaction, and your designated beneficiary will be required to report 100 percent of the built -up earnings in the account from inception on his tax return for that year.

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