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If you’re thinking about ways to fund your child’s education, the federal government has provided an incentive—the Coverdell Education Savings Account (Coverdell ESA), formerly known as the Education IRA. Contributions are not deductible, but tax-free withdrawals can be made when used to pay for eligible education expenses.
There are, however, income eligibility limits for parents who wish to open Coverdell ESAs for their children. The ability to make contributions phases out for single taxpayers with adjusted gross incomes (AGIs) between $95,000 and $110,000, and for married couples filing joint returns with AGIs between $190,000 and $220,000.
You may contribute up to a maximum of $2,000 annually per child before the designated student reaches age 18. For gift tax purposes, contributions fall under the annual gift tax exclusion limits for singles and married couples ($14,000 and $28,000, respectively, in 2013). Be sure to keep in mind that, if you also contribute to a 529 plan for the same child during the same year, you will need to add these gifts together to determine your gift tax filings.
There is no limit to the number of accounts that may be held in the child’s name or the number of people who may make contributions to a Coverdell ESA—as long as total contributions remain within the $2,000 annual limit per child. If multiple accounts are established and more than $2,000 is contributed in total, the excess is subject to a 6% excise tax penalty. You can, however, eliminate the penalty by withdrawing the excess contributions (and any earnings) before the due date for the beneficiary’s tax return for that year. The withdrawal would be considered income, and it would be subject to taxation.
Coverdell ESAs can be used to pay for more than just college expenses. Funds can also be used to pay for elementary and secondary school expenses, including the purchase of computer systems, educational software, and Internet access for the child.
The beneficiary must spend a Coverdell ESA by his or her 30th birthday. If the designated child does not use the funds for educational purposes by that age, the account may be rolled over for use by another member of the family who is under age 30. Withdrawals from a Coverdell ESA that are not used for qualified education expenses may be subject to both income taxes and a 10% penalty.
Finally, if you’re hoping your child qualifies for financial aid in college, you may want to think twice about setting up a Coverdell ESA. It’s important to note that a Coverdell ESA must be set up in the child’s name. Financial aid formulas, in determining how much a family can afford to contribute to the cost of college, count assets held in a child’s name much more heavily than those held in the parents’ names.