Pub. 970, Tax Benefits for Education |
2004 Tax Year |
Chapter 7 - Coverdell Education Savings Account (ESA)
This is archived information that pertains only to the 2004 Tax Year. If you are looking for information for the current tax year, go to the Tax Prep Help Area.
If your modified adjusted gross income (MAGI) is less than $110,000 ($220,000 if filing a joint return), you may be able to
establish a Coverdell
ESA to finance the qualified education expenses of a designated beneficiary. For most taxpayers, MAGI is the adjusted gross
income as figured on their
federal income tax return.
There is no limit on the number of separate Coverdell ESAs that can be established for a designated beneficiary. However,
total contributions for
the beneficiary in any year cannot be more than $2,000, no matter how many accounts have been established. See Contributions, later.
This benefit applies not only to higher education expenses, but also to elementary and secondary education expenses.
What is the tax benefit of the Coverdell ESA.
Contributions to a Coverdell ESA are not deductible, but amounts deposited in the account grow tax free until distributed.
If, for a year, distributions from an account are not more than a designated beneficiary's qualified education expenses
at an eligible educational
institution, the beneficiary will not owe tax on the distributions. See Tax-Free Distributions, later.
Table 7-1
summarizes the main features of the Coverdell ESA.
A Coverdell ESA is a trust or custodial account created or organized in the United States only for the purpose
of paying the qualified education expenses of the designated beneficiary of the account.
When the account is established, the designated beneficiary must be under age 18 or a special needs beneficiary.
To be treated as a Coverdell ESA, the account must be designated as a Coverdell ESA when it is created.
The document creating and governing the account must be in writing and must satisfy the following requirements.
-
The trustee or custodian must be a bank or an entity approved by the IRS.
-
The document must provide that the trustee or custodian can only accept a contribution that meets all of the following conditions.
-
Is in cash.
-
Is made before the beneficiary reaches age 18, unless the beneficiary is a special needs beneficiary.
-
Would not result in total contributions for the year (not including rollover contributions) being more than $2,000.
-
Money in the account cannot be invested in life insurance contracts.
-
Money in the account cannot be combined with other property except in a common trust fund or common investment fund.
-
The balance in the account generally must be distributed within 30 days after the earlier of the following events.
-
The beneficiary reaches age 30, unless the beneficiary is a special needs beneficiary.
-
The beneficiary's death.
As of this printing, regulations defining a “special needs beneficiary” have not been released. If available, the definition will be included
in Publication 553, Highlights of 2004 Tax Changes, which will be issued in early 2005.
Table 7-1. |
Coverdell ESA at a Glance |
|
Do not rely on this table alone. It provides only general highlights. See the text for definitions of terms in bold type and
for
more complete explanations. |
Question |
Answer |
What is a Coverdell ESA? |
A savings account that is set up to pay the qualified education expenses of a designated beneficiary. |
Where can it be established? |
It can be opened in the United States at any bank or other IRS-approved entity that offers Coverdell ESAs. |
Who can have a Coverdell ESA? |
Any beneficiary who is under age 18 or is a special needs beneficiary. |
Who can contribute to a Coverdell ESA? |
Generally, any individual (including the beneficiary) whose modified adjusted gross income for the year is less than
$110,000 ($220,000 in the case of a joint return). |
Are distributions tax free? |
Yes, if the distributions are not more than the beneficiary's adjusted qualified education expenses for the year. |
Qualified Education Expenses
Generally, these are expenses required for the enrollment or attendance of the designated beneficiary at an eligible educational
institution. For
purposes of Coverdell ESAs, the expenses can be either qualified higher education expenses or qualified elementary and secondary
education expenses.
Designated beneficiary.
This is the individual named in the document creating the trust or custodial account to receive the benefit of the
funds in the account.
Eligible Educational Institution
For purposes of Coverdell ESAs, an eligible educational institution can be either an eligible postsecondary school or an eligible
elementary or
secondary school.
Eligible postsecondary school.
This is any college, university, vocational school, or other postsecondary educational institution eligible to participate
in a student aid program
administered by the Department of Education. It includes virtually all accredited, public, nonprofit, and proprietary (privately
owned profit-making)
postsecondary institutions. The educational institution should be able to tell you if it is an eligible educational institution.
Certain educational institutions located outside the United States also participate in the U.S. Department of Education's
Federal Student Aid (FSA)
programs. You can find a list of these foreign schools on the Department of Education's website at
www.fafsa.ed.gov/index.htm. Click on
“ Find my school codes.” Complete the two items on the first page and click “ Next.” Follow the instructions to search for a foreign school.
Eligible elementary or secondary school.
This is any public, private, or religious school that provides elementary or secondary education (kindergarten through
grade 12), as determined
under state law.
Qualified Higher Education Expenses
These are expenses related to enrollment or attendance at an eligible postsecondary school. As shown in the following list,
to be qualified, some
of the expenses must be required by the school and some must be incurred by students who are enrolled at least half-time.
Contributions to qualified
tuition programs can be qualified education expenses (see item (4) in the following list).
-
The following expenses must be required for enrollment or attendance of a designated beneficiary at an eligible postsecondary
school.
-
Tuition and fees.
-
Books, supplies, and equipment.
-
Expenses for special needs services needed by a special needs beneficiary must be incurred in connection with enrollment or
attendance at an
eligible postsecondary school. (See Caution in the next column.)
-
Expenses for room and board must be incurred by students who are enrolled at least half-time (defined in the next column).
The expense for room and board qualifies only to the extent that it is not more than the greater of the following two amounts.
-
The allowance for room and board, as determined by the school, that was included in the cost of attendance (for federal financial
aid
purposes) for a particular academic period and living arrangement of the student.
-
The actual amount charged if the student is residing in housing owned or operated by the school.
-
Any contribution to a qualified tuition program (QTP) must be on behalf of the designated beneficiary of the Coverdell ESA.
(See chapter 8,
Qualified Tuition Program (QTP).)
Half-time student.
A student is enrolled “ at least half-time” if he or she is enrolled for at least half the full-time academic work load for the course of study
the student is pursuing, as determined under the standards of the school where the student is enrolled.
Qualified Elementary and Secondary Education Expenses
These are expenses related to enrollment or attendance at an eligible elementary or secondary school. As shown in the following
list, to be
qualified, some of the expenses must be required or provided by the school. There are special rules for computer-related expenses.
-
The following expenses must be incurred by a designated beneficiary in connection with enrollment or attendance at an eligible
elementary or
secondary school.
-
Tuition and fees.
-
Books, supplies, and equipment.
-
Academic tutoring.
-
Special needs services for a special needs beneficiary. (See Caution below.)
-
The following expenses must be required or provided by an eligible elementary or secondary school in connection with attendance
or
enrollment at the school.
-
Room and board.
-
Uniforms.
-
Transportation.
-
Supplementary items and services (including extended day programs).
-
The purchase of computer technology, equipment, or Internet access and related services is a qualified elementary and secondary
education
expense if it is to be used by the beneficiary and the beneficiary's family during any of the years the beneficiary is in
elementary or secondary
school. (This does not include expenses for computer software designed for sports, games, or hobbies unless the software is
predominantly educational
in nature.)
As of this printing, regulations defining a “special needs beneficiary” have not been released. If available, the definition will be included
in Publication 553, Highlights of 2004 Tax Changes, which will be issued in early 2005.
Any individual (including the designated beneficiary) can contribute to a Coverdell ESA if the individual's
modified adjusted gross income (MAGI) (defined later under Contribution Limits) for the year is less than $110,000. For individuals filing
joint returns, that amount is $220,000.
Organizations, such as corporations and trusts, can also contribute to Coverdell ESAs. There is no requirement that an organization's
income be
below a certain level.
Contributions must meet all of the following requirements.
-
They must be in cash.
-
They cannot be made after the beneficiary reaches age 18, unless the beneficiary is a special needs beneficiary, and
-
They must be made by the due date of the contributor's tax return (not including extensions).
Contributions can be made to one or several Coverdell ESAs for the same designated beneficiary provided that the total contributions
are not more
than the contribution limits (defined later) for a year.
Contributions can be made, without penalty, to both a Coverdell ESA and a QTP in the same year for the same beneficiary.
Table 7-2 summarizes many of the features of contributing to a Coverdell ESA.
Table 7-2. |
Coverdell ESA Contributions at a Glance |
|
Do not rely on this table alone. It provides only general highlights. See the text for more complete
explanations. |
Question |
Answer |
Are contributions deductible? |
No. |
Why should someone contribute to a Coverdell ESA? |
Earnings on the account grow tax free until distributed. |
What is the annual contribution limit per designated beneficiary? |
$2,000 for each designated beneficiary. |
What if more than one Coverdell ESA has been opened for the same designated beneficiary? |
The annual contribution limit is $2,000 for each beneficiary, no matter how many Coverdell ESAs are set up for that
beneficiary. |
What if more than one individual makes contributions for the same designated beneficiary? |
The annual contribution limit is $2,000 per beneficiary, no matter how many individuals contribute. |
Can contributions other than cash be made to a Coverdell ESA? |
No. |
When must contributions stop? |
No contributions can be made to a beneficiary's Coverdell ESA after he or she reaches age 18, unless the
beneficiary is a special needs beneficiary. |
There are two yearly limits:
-
One on the total amount that can be contributed for each designated beneficiary in any year, and
-
One on the amount that any individual can contribute for any one designated beneficiary for a year.
Limit for each designated beneficiary.
For 2004, the total of all contributions to all Coverdell ESAs set up for the benefit of any one designated beneficiary
cannot be more than $2,000.
This includes contributions (other than rollovers) to all the beneficiary's Coverdell ESAs from all sources. Rollovers are
discussed under
Rollovers and Other Transfers, later.
Example.
When Maria Luna was born in 2003, three separate Coverdell ESAs were set up for her, one by her parents, one by her grandfather,
and one by her
aunt. In 2004, the total of all contributions to Maria's three Coverdell ESAs cannot be more than $2,000. For example, if
her grandfather contributed
$2,000 to one of her Coverdell ESAs, no one else could contribute to any of her three accounts. Or, if her parents contributed
$1,000 and her aunt
$600, her grandfather or someone else could contribute no more than $400. These contributions could be put into any of Maria's
Coverdell ESA accounts.
Limit for each contributor.
Generally, you can contribute up to $2,000 for each designated beneficiary for 2004. This is the most you can contribute
for the benefit of any one
beneficiary for the year, regardless of the number of Coverdell ESAs set up for the beneficiary.
Example.
The facts are the same as in the previous example except that Maria Luna's older brother, Edgar, also has a Coverdell ESA.
If their grandfather
contributed $2,000 to Maria's Coverdell ESA in 2004, he could also contribute $2,000 to Edgar's Coverdell ESA.
Reduced limit.
Your contribution limit may be reduced. If your modified adjusted gross income (MAGI) (defined below) is between $95,000
and $110,000 (between
$190,000 and $220,000 if filing a joint return), the $2,000 limit for each designated beneficiary is gradually reduced (see
Figuring the
limit, later). If your MAGI is $110,000 or more ($220,000 or more if filing a joint return), you cannot contribute to anyone's
Coverdell ESA.
Modified adjusted gross income (MAGI).
For most taxpayers, MAGI is adjusted gross income (AGI) as figured on their federal income tax return.
MAGI when using Form 1040A.
If you file Form 1040A, your MAGI is the AGI on line 22 of that form.
MAGI when using Form 1040.
If you file Form 1040, your MAGI is the AGI on line 37 of that form, modified by adding back any:
-
Foreign earned income exclusion,
-
Foreign housing exclusion,
-
Exclusion of income for bona fide residents of American Samoa, and
-
Exclusion of income from Puerto Rico.
You can use Worksheet 7-1
to figure your MAGI.
Worksheet 7-1.MAGI for a Coverdell ESA |
1. |
Enter your adjusted gross income
(Form 1040, line 37) |
|
1. |
|
2. |
Enter your foreign earned income exclusion and/or housing exclusion (Form 2555, line 43, or Form
2555-EZ, line 18) |
|
2. |
|
|
|
3. |
Enter the amount of income from Puerto Rico that you
are excluding |
|
3. |
|
|
|
4. |
Enter the amount of income from American Samoa that you are excluding (Form 4563, line 15) |
|
4. |
|
|
|
5. |
Add the amounts on
lines 2, 3, and 4 |
|
5. |
|
6. |
Add the amounts on lines 1 and 5.
This is your modified adjusted
gross income |
|
6. |
|
Figuring the limit.
To figure the limit on the amount you can contribute for each designated
beneficiary, multiply $2,000 by a fraction. The numerator (top number) is your MAGI minus $95,000 ($190,000 if filing a joint
return). The denominator
(bottom number) is $15,000 ($30,000 if filing a joint return). Subtract the result from $2,000. This is the amount you can
contribute for each
beneficiary. You can use Worksheet 7-2
to figure the limit on your contributions.
Worksheet 7-2.Coverdell ESA Contribution Limit |
1. |
Maximum contribution |
|
1. |
$2,000 |
2. |
Enter your modified adjusted gross income (MAGI) for purposes of figuring the
contribution limit to a Coverdell ESA (see definition or Worksheet 7-1 earlier) |
|
2. |
|
3. |
Enter $190,000 if married filing jointly; $95,000 for all other filers |
|
3. |
|
4. |
Subtract line 3 from line 2. If zero or less, enter -0- on line 4, skip lines 5
through 7, and enter $2,000 on line 8 |
|
4. |
|
5. |
Enter $30,000 if married filing jointly; $15,000 for all other filers |
|
5. |
|
|
Note.If the amount on line 4 is greater than or equal to the amount
on line 5, stop here. You are not allowed to contribute to a Coverdell ESA for 2004. |
|
|
|
6. |
Divide line 4 by line 5 and enter the result as a decimal (rounded to at least 3
places) |
|
6. |
. |
7. |
Multiply line 1 by line 6 |
|
7. |
|
8. |
Subtract line 7 from line 1 |
|
8. |
|
Note:The total Coverdell ESA contributions from all sources for the designated
beneficiary during the tax year may not exceed $2,000. |
Example.
Paul, who is single, had MAGI of $96,500 for 2004. Paul can contribute up to $1,800 in 2004 for each beneficiary, as shown
in the illustrated
Worksheet 7-2.
Worksheet 7-2. |
Coverdell ESA Contribution
Limit—Illustrated |
1. |
Maximum contribution |
|
1. |
$2,000 |
2. |
Enter your modified adjusted gross income (MAGI) for purposes of figuring the
contribution limit to a Coverdell ESA (see definition or Worksheet 7-1 earlier) |
|
2. |
96,500 |
3. |
Enter $190,000 if married filing jointly; $95,000 for all other filers |
|
3. |
95,000 |
4. |
Subtract line 3 from line 2. If zero or less, enter -0- on line 4, skip lines 5
through 7, and enter $2,000 on line 8 |
|
4. |
1,500 |
5. |
Enter $30,000 if married filing jointly; $15,000 for all other filers |
|
5. |
15,000 |
|
Note.If the amount on line 4 is greater than or equal to the amount
on line 5,
stop here. You are not allowed to
contribute to a Coverdell ESA for 2004. |
|
|
|
6. |
Divide line 4 by line 5 and enter the result as a decimal (rounded to at least 3
places) |
|
6. |
.100 |
7. |
Multiply line 1 by line 6 |
|
7. |
200 |
8. |
Subtract line 7 from line 1 |
|
8. |
1,800 |
Note: The total Coverdell ESA contributions from all sources for the designated
beneficiary during the tax year may not exceed $2,000. |
Additional Tax on Excess Contributions
The beneficiary must pay a 6% excise tax each year on excess contributions that are in a Coverdell ESA at the end of the year.
Excess contributions
are the total of the following two amounts.
-
Contributions to any designated beneficiary's Coverdell ESA for the year that are more than $2,000 (or, if less, the total
of each
contributor's limit for the year, as discussed earlier).
-
Excess contributions for the preceding year, reduced by the total of the following two amounts:
-
Distributions (other than those rolled over as discussed later) during the year, and
-
The contribution limit for the current year minus the amount contributed for the current year.
Exceptions.
The excise tax does not apply if excess contributions made during 2004 (and any earnings on them) are distributed
before the first day of the sixth
month of the following tax year (June 1, 2005, for a calendar year taxpayer).
However, you must include the distributed earnings in gross income for the year in which the excess contribution was
made. You should receive Form
1099-Q, Payments From Qualified Education Programs (Under Sections 529 and 530),
from each institution from which excess contributions were distributed. Box 2 of that form will show the
amount of earnings on your excess contributions. Enter the amount of earnings on line 21 of Form 1040. For more information,
see Taxable
Distributions, later.
The excise tax does not apply to any rollover contribution.
Example.
In 2003, Greta's parents and grandparents contributed a total of $2,300 to Greta's Coverdell ESA, an excess contribution of
$300. Because Greta did
not withdraw the excess before June 1, 2004, she had to pay an additional tax of $18 (6% × $300) when she filed her 2003 tax
return.
In 2004, excess contributions to the same account totaled $500, but Greta withdrew $250 to use for qualified education expenses.
Using the steps
shown under Additional Tax on Excess Contributions, Greta figures the excess contribution in her account at the end of 2004 as follows.
(1) |
|
$500 excess paid in 2004 |
|
|
+ (2) |
|
$300 excess contributions at end
of 2003 |
|
|
- (2a) |
|
$250 distribution during 2004 |
|
|
|
|
$550 excess at end of 2004 |
|
× 6%=$33 |
|
|
|
|
|
If Greta limits 2005 contributions to $1,450 ($2,000 maximum allowed - $550 excess contributions from 2004), she will not
owe any
additional tax in 2005 for excess contributions.
Figuring the additional tax.
You figure this excise tax in Part V, Form 5329, Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored
Accounts. Report the
additional tax on Form 1040, line 59.
Rollovers and Other Transfers
Assets can be rolled over from one Coverdell ESA to another or the designated beneficiary can be changed. The beneficiary's
interest can be
transferred to a spouse or former spouse because of divorce.
Any amount distributed from a Coverdell ESA is not taxable if it is rolled over to another Coverdell ESA for the benefit of
the same beneficiary or
a member of the beneficiary's family (including the beneficiary's spouse) who is under age 30. This age limitation does not
apply if the new
beneficiary is a special needs beneficiary.
An amount is rolled over if it is paid to another Coverdell ESA within 60 days after the date of the distribution.
Members of the beneficiary's family.
For these purposes, the beneficiary's family includes the beneficiary's spouse and the following other relatives of
the beneficiary.
-
Son or daughter or descendant of son or daughter.
-
Stepson or stepdaughter.
-
Brother, sister, stepbrother, or stepsister.
-
Father or mother or ancestor of either.
-
Stepfather or stepmother.
-
Son or daughter of a brother or sister.
-
Brother or sister of father or mother.
-
Son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, or sister-in-law.
-
The spouse of any individual listed above.
-
First cousin.
Example.
When Aaron graduated from college last year he had $5,000 left in his Coverdell ESA. He wanted to give this money to his younger
sister, who was
still in high school. In order to avoid paying tax on the distribution of the amount remaining in his account, Aaron contributed
the same amount to
his sister's Coverdell ESA within 60 days of the distribution.
Only one rollover per Coverdell ESA is allowed during the 12-month period ending on the date of the payment or distribution.
Changing the Designated Beneficiary
The designated beneficiary can be changed to a member of the beneficiary's family (defined above). There are no tax consequences
if, at the time of
the change, the new beneficiary is under age 30 or a special needs beneficiary.
Example.
Assume the same situation as in the last example. Instead of closing his Coverdell ESA and paying the distribution into his
sister's Coverdell ESA,
Aaron could have instructed the trustee of his account to simply change the name of the beneficiary on his account to that
of his sister.
Transfer Because of Divorce
If a spouse or former spouse receives a Coverdell ESA under a divorce or separation instrument, it is not a taxable transfer.
After the transfer,
the spouse or former spouse treats the Coverdell ESA as his or her own.
Example.
In their divorce settlement, Peg received her ex-husband's Coverdell ESA. In this process, the account was transferred into
her name. Peg now
treats the funds in this Coverdell ESA as if she were the original owner.
The designated beneficiary of a Coverdell ESA can take a distribution at any time. Whether the distributions
are tax free depends, in part, on whether the distributions are equal to or less than the amount of adjusted qualified education
expenses (defined
next) that the beneficiary has in the same tax year.
See Table 7-3,
on the next page, for highlights.
Adjusted qualified education expenses.
To determine if total distributions for the year are more than the amount of qualified education expenses, reduce
total qualified education
expenses by any tax-free educational assistance.
Tax-free educational assistance includes:
-
The tax-free part of scholarships and fellowships (see chapter 1),
-
Veterans' educational assistance (see chapter 1),
-
Pell grants (see chapter 1),
-
Employer-provided educational assistance (see chapter 11), and
-
Any other nontaxable (tax-free) payments (other than gifts or inheritances) received as educational assistance.
The amount you get by subtracting tax-free educational assistance from your total qualified education expenses is your adjusted
qualified
education expenses.
Generally, distributions are tax free if they are not more than the beneficiary's adjusted qualified education expenses for
the year.
A portion of the distributions is generally taxable to the beneficiary if the distributions are more than the beneficiary's
adjusted qualified
education expenses for the year.
Excess distribution.
This is the part of the total distribution that is more than the beneficiary's adjusted qualified education expenses
for the year.
Earnings and basis.
You will receive a Form 1099-Q for each of the Coverdell ESAs from which money was distributed in 2004. The amount
of your gross distribution will
be shown in box 1. For 2004, instead of dividing the gross distribution between your earnings (box 2) and your basis (already-taxed
amount) (box 3),
the payer or trustee may report the fair market value (account balance) of the Coverdell ESA as of December 31, 2004. This
will be shown in the blank
box below boxes 5 and 6.
Table 7-3. |
Coverdell ESA Distributions at a Glance |
|
Do not rely on this table alone. It provides only general highlights. See the text for definitions of terms in bold type and
for
more complete explanations. |
Question |
Answer |
Is a distribution from a Coverdell ESA to pay for a designated beneficiary's qualified education expenses tax
free? |
Generally, yes, to the extent the amount of the distribution is not more than the designated beneficiary's adjusted
qualified education expenses. |
After the designated beneficiary completes his or her education at an eligible educational institution,
can amounts remaining in the Coverdell ESA be distributed? |
Yes. Amounts must be distributed when the designated beneficiary reaches age 30, unless he or she is a
special needs beneficiary. Also, certain transfers to members of the beneficiary's family are permitted. |
Does the designated beneficiary need to be enrolled for a minimum number of courses to take a tax-free
distribution? |
No. |
Figuring the Taxable Portion of a Distribution
The taxable portion is the amount of the excess distribution that represents earnings that have accumulated tax free in the
account. Figure the
taxable portion for 2004 as shown in the following steps.
-
Multiply the amount distributed by a fraction. The numerator is the basis (contributions not previously distributed) at the
end of 2003 plus
total contributions for 2004 and the denominator is the value (balance) of the account at the end of 2004 plus the amount
distributed during
2004.
-
Subtract the amount figured in (1) from the total amount distributed during 2004. This is the amount of earnings included
in the
distribution(s).
-
Multiply the amount of earnings figured in (2) by a fraction. The numerator is the adjusted qualified education expenses paid
during 2004
and the denominator is the total amount distributed during 2004.
-
Subtract the amount figured in (3) from the amount figured in (2). This is the amount the beneficiary must include in income.
The taxable amount must be reported on Form 1040, line 21.
Example.
You received an $850 distribution from your Coverdell ESA, to which $1,500 had been contributed before 2004. There were no
contributions in 2004.
This is your first distribution from the account, so your basis in the account on December 31, 2003, was $1,500. The value
(balance) of your account
on December 31, 2004, was $950. You had $700 of adjusted qualified education expenses (AQEE) for the year. Using the steps
above, figure the taxable
portion of your distribution as follows.
|
1. |
$850 (distribution) |
× |
$1,500 basis + $0 contributions $950 value + $850 distribution |
|
|
|
|
|
=$708 (basis portion of distribution) |
|
|
2. |
$850 (distribution)-$708 (basis portion of
distribution) |
|
|
=$142 (earnings included in distribution) |
|
3. |
$142 (earnings) |
× |
$700 AQEE $850 distribution |
|
|
|
|
|
=$117 (tax-free earnings) |
|
|
4. |
$142 (earnings included in distribution)-$117 (tax-free earnings) |
|
|
=$25 (taxable earnings) |
|
|
|
|
|
|
|
|
You must include $25 in income as distributed earnings not used for qualified education expenses. Report this amount on Form
1040, line 21,
listing the type and amount of income on the dotted line.
Worksheet 7-3,
later in this chapter, can help you figure your adjusted qualified education expenses, how
much of your distribution must be included in income, and the remaining basis in your Coverdell ESAs.
Coordination With Hope and Lifetime Learning Credits
The Hope or lifetime learning credit can be claimed in the same year the beneficiary takes a tax-free distribution from a
Coverdell ESA, as long as
the same expenses are not used for both benefits. This means the beneficiary must reduce qualified higher education expenses
by tax-free educational
assistance, and then further reduce them by any expenses taken into account in determining a Hope or lifetime learning credit.
Example.
Derek Green had $4,200 of qualified higher education expenses for 2004, his first year in college. He paid his college expenses
from the following
sources.
|
Partial tuition scholarship (tax free) |
$1,500 |
|
|
Coverdell ESA distribution |
1,000 |
|
|
Gift from parents |
500 |
|
|
Earnings from part-time job |
1,200 |
|
|
|
|
|
Of his $4,200 of qualified higher education expenses, $2,700 was tuition and related expenses that also qualified for a Hope
credit. Derek's
parents claimed a $1,500 Hope credit on their tax return.
Before Derek can determine the taxable portion of his distribution, he must reduce his total qualified higher education expenses.
|
Total qualified higher education expenses |
$4,200 |
|
|
Minus: Tax-free educational assistance |
-1,500 |
|
|
Minus: Expenses taken into account in
figuring Hope credit |
-2,000 |
|
|
Equals: Adjusted qualified higher education
expenses (AQHEE) |
$ 700 |
|
Since the adjusted qualified higher education expenses ($700) are less than the Coverdell ESA distribution, part of the distribution
will be
taxable. The balance in Derek's account was $1,800 on December 31, 2004. Prior to 2004, $2,200 had been contributed to this
account. Contributions for
2004 totaled $300. Using the four steps outlined earlier, Derek figures the taxable portion of his distribution as shown below.
|
1. |
$1,000 (distribution) |
× |
$2,200 basis + $300 contributions $1,800 value + $1,000 distribution |
|
|
|
|
|
=$893 (basis portion of distribution) |
|
|
2. |
$1,000 (distribution)-$893 (basis portion of
distribution) |
|
|
= $107 (earnings included in distribution) |
|
3. |
$107 (earnings) |
× |
$700 AQHEE $1,000 distribution |
|
|
|
|
|
=$75 (tax-free earnings) |
|
|
4. |
$107 (earnings included in distribution)-$75 (tax-free earnings) |
|
|
=$32 (taxable earnings) |
|
|
|
|
|
|
|
|
Derek must include $32 in income. This is the amount of distributed earnings not used for adjusted qualified higher education
expenses.
Coordination With Qualified Tuition Program (QTP) Distributions
If a designated beneficiary receives distributions from both a Coverdell ESA and a QTP in the same year, and the total distribution
is more than
the beneficiary's adjusted qualified higher education expenses, those expenses must be allocated between the distribution
from the Coverdell ESA and
the distribution from the QTP before figuring how much of each distribution is taxable. The following two examples illustrate
possible allocations.
Example 1.
In 2004, Beatrice graduated from high school and began her first semester of college. That year, she had $1,000 of qualified
elementary and
secondary education expenses (QESEE) for high school and $3,000 of qualified higher education expenses (QHEE) for college.
To pay these expenses,
Beatrice withdrew $800 from her Coverdell ESA and $4,200 from her QTP. No one claimed Beatrice as a dependent, nor was she
eligible for an education
credit. She did not receive any tax-free educational assistance in 2004. Beatrice must allocate her total qualified education
expenses between the two
distributions.
Example 2.
Assume the same facts as in Example 1, except that Beatrice withdrew $1,800 from her Coverdell ESA and $3,200 from her QTP. In this
case, she allocates her qualified education expenses as follows.
|
$3,000 QHEE |
× |
$800 ESA distribution $4,000 total distribution |
= |
$600
QHEE (ESA) |
|
|
$3,000 QHEE |
× |
$3,200 QTP distribution $4,000 total distribution |
= |
$2,400
QHEE (QTP) |
|
The above examples show two types of allocation between distributions from a Coverdell ESA and a QTP. However, you do not
have to allocate your
expenses in the same way. You can use any reasonable method.
Losses on Coverdell ESA Investments
If you have a loss on your investment in a Coverdell ESA, you may be able to take the loss on your income tax return. You
can take the loss only
when all amounts from that account have been distributed and the total distributions are less than your unrecovered basis.
Your basis is the total
amount of contributions to that Coverdell ESA. You claim the loss as a miscellaneous itemized deduction on Schedule A (Form
1040), line 22, subject to
the 2%-of-adjusted-gross-income limit. For more information and examples of the calculation, see Losses on QTP Investments in chapter 8
under Figuring the Taxable Portion of a Distribution.
Additional Tax on Taxable Distributions
Generally, if you receive a taxable distribution, you also must pay a 10% additional tax on the amount included in income.
Exceptions.
The 10% additional tax does not apply to distributions:
-
Paid to a beneficiary (or to the estate of the designated beneficiary) on or after the death of the designated beneficiary.
-
Made because the designated beneficiary is disabled. A person is considered to be disabled if he or she shows proof that he
or she cannot do
any substantial gainful activity because of his or her physical or mental condition. A physician must determine that his or
her condition can be
expected to result in death or to be of long-continued and indefinite duration.
-
Included in income because the designated beneficiary received:
-
A tax-free scholarship or fellowship (see chapter 1),
-
Veterans' educational assistance (see chapter 1),
-
Employer-provided educational assistance (see chapter 11), or
-
Any other nontaxable (tax-free) payments (other than gifts or inheritances) received as educational assistance.
-
Made on account of the attendance of the designated beneficiary at a U.S. military academy (such as West Point). This exception
applies only
to the extent that the amount of the distribution does not exceed the costs of advanced education (as defined in title 10
of the U.S. Code)
attributable to such attendance.
-
Included in income only because the qualified education expenses were taken into account in determining the Hope or lifetime
learning credit
(see chapters 2 and 3).
-
Made before June 1, 2005, of an excess 2004 contribution (and any earnings on it). The distributed earnings must be included
in gross income
for the year in which the excess contribution was made.
Exception (3) applies only to the extent the distribution is not more than the scholarship, allowance, or payment.
Figuring the additional tax.
Use Part II of Form 5329, Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts,
to figure any additional tax. Report the amount on Form 1040, line 59.
Worksheet 7-3.Coverdell ESA—Taxable Distributions and Basis |
(Keep for Your Records) |
How to complete this worksheet. |
•
•
• |
Complete Part I, lines A through H, on only one worksheet.
Complete a separate Part II, lines 1 through 15, for each of your Coverdell ESAs.
Complete Part III, the Summary (line 16), on only one worksheet. |
Part I.Qualified Education Expenses (Complete for total expenses) |
|
|
|
A. |
Enter your total qualified education expenses for 2004 |
|
A. |
|
B. |
Enter those qualified education expenses paid for with tax-free educational assistance (for example,
tax-free scholarships, veterans' educational benefits, Pell grants, employer-provided educational assistance) |
|
B. |
|
|
|
|
C. |
Enter those qualified higher education expenses deducted on
Schedule C or C-EZ (Form 1040), Schedule F (Form 1040), or as
a miscellaneous itemized deduction on Schedule A (Form 1040) |
|
C. |
|
|
|
|
D. |
Enter those qualified higher education expenses on which
a Hope or lifetime learning credit was based |
|
D. |
|
|
|
|
E. |
Add lines B, C, and D |
|
E. |
|
F. |
Subtract line E from line A. This is your adjusted qualified education expense for 2004 |
|
F. |
|
G. |
Enter your total distributions from all Coverdell ESAs during 2004. Do not include
rollovers
or the return of excess contributions (see instructions) |
|
G. |
|
H. |
Divide line F by line G. Enter the result as a decimal (rounded to at least 3 places). If the
result is 1.000 or more, enter 1.000 |
|
H. |
. |
Part II.Taxable Distributions and Basis (Complete separately for
each account) |
1. |
Enter the amount contributed to this Coverdell ESA for 2004, including
contributions made for 2004 from January 1, 2005, through April 15, 2005. Do not include rollovers or the return of excess contributions |
|
1. |
|
2. |
Enter your basis in this Coverdell ESA as of December 31, 2003 (see
instructions) |
|
2. |
|
3. |
Add lines 1 and 2 |
|
3. |
|
4. |
Enter the total distributions from this Coverdell ESA during 2004. Do
not include rollovers
or the return of excess contributions (see instructions) |
|
4. |
|
5. |
Multiply line 4 by line H. This is the amount of adjusted qualified
education expense attributable to this Coverdell ESA |
|
5. |
|
|
|
|
6. |
Subtract line 5 from line 4 |
|
6. |
|
|
|
|
7. |
Enter the total value of this Coverdell ESA as of December 31, 2004,
plus any outstanding rollovers (see instructions) |
|
7. |
|
|
|
|
8. |
Add lines 4 and 7 |
|
8. |
|
|
|
|
9. |
Divide line 3 by line 8. Enter the result as a decimal (rounded to
at least 3 places). If the result is 1.000 or more, enter 1.000 |
|
9. |
. |
|
|
|
10. |
Multiply line 4 by line 9. This is the amount of basis allocated to your
distributions, and is tax free |
|
10. |
|
|
Note:If line 6 is zero, skip lines 11 through 13, enter -0- on line 14, and
go to line 15. |
|
|
|
11. |
Subtract line 10 from line 4 |
|
11. |
|
12. |
Divide line 5 by line 4. Enter the result as a decimal (rounded to
at least 3 places). If the result is 1.000 or more, enter 1.000 |
|
12. |
. |
|
|
|
13. |
Multiply line 11 by line 12. This is the amount of qualified education
expenses allocated to your distributions, and is tax free |
|
13. |
|
14. |
Subtract line 13 from line 11. This is the portion of the distributions from this
Coverdell ESA in 2004 that you must include in income |
|
14. |
|
15. |
Subtract line 10 from line 3. This is your basis in this Coverdell ESA as of December
31, 2004 |
|
15. |
|
Part III.Summary (Complete only once) |
|
|
|
16. |
Taxable amount. Add together all amounts on line 14 for all your Coverdell ESAs.
Enter here
and include on Form 1040, line 21, listing the type and amount of income on the dotted line |
|
16. |
|
When Assets Must Be Distributed
Any assets remaining in a Coverdell ESA must be distributed when either one of the following two events occurs.
-
The designated beneficiary reaches age 30. In this case, the remaining assets must be distributed within 30 days after the
beneficiary
reaches age 30. However, this rule does not apply if the beneficiary is a special needs beneficiary.
-
The designated beneficiary dies before reaching age 30. In this case, the remaining assets must generally be distributed within
30 days
after the date of death.
Exception for Transfer to Surviving Spouse or Family Member
If a Coverdell ESA is transferred to a surviving spouse or other family member as the result of the death of the designated
beneficiary, the
Coverdell ESA retains its status. (Family member was defined earlier under Rollovers.) This means the spouse or other family member can
treat the Coverdell ESA as his or her own and does not need to withdraw the assets until he or she reaches age 30. This age
limitation does not apply
if the new beneficiary is a special needs beneficiary. There are no tax consequences as a result of the transfer.
How To Figure the Taxable Earnings
When a total distribution is made because the designated beneficiary either reached age 30 or died, the earnings that accumulated
tax free in the
account must be included in taxable income. You determine these earnings as shown in the following two steps.
-
Multiply the amount distributed by a fraction. The numerator is the basis (contributions not previously distributed) at the
end of 2003 plus
total contributions for 2004 and the denominator is the balance in the account at the end of 2004 plus the amount distributed
during 2004.
-
Subtract the amount figured in (1) from the total amount distributed during 2004. The result is the amount of earnings included
in the
distribution.
For an example, see steps (1) and (2) of the Example under Figuring the Taxable Portion of a Distribution, earlier.
The beneficiary or other person receiving the distribution must report this amount on Form 1040, line 21,
listing the type and amount of income on the dotted line.
Worksheet 7-3 Instructions.Coverdell ESA—Taxable Distributions and Basis |
Line G. |
Enter the total distributions received from all Coverdell ESAs during 2004. Do not include amounts rolled over to
another ESA within 60 days (only one rollover is allowed during any 12-month period). Also, do not include excess contributions
that were distributed
with the related earnings (or less any loss) before the first day of the sixth month of the tax year following the year for
which the contributions
were made. |
Line 2. |
Your basis (amount already taxed) in this Coverdell ESA as of December 31, 2003, is the total of: |
|
•All contributions to this Coverdell ESA before 2004
•Minus the tax-free portion of any distributions from this Coverdell ESA before 2004. |
|
If your last distribution from this Coverdell ESA was before 2002, you must start with the basis in your account as of the
end of the last year
in which you took a distribution. You can find that amount on the last line of the worksheet in the Instructions for Form
8606, Nondeductible IRAs,
that you completed for that year. You can determine your basis in this Coverdell ESA as of December 31, 2003, by adding to
the basis as of the end of
that year any contributions made to that account after the year of the distribution and before 2004. |
Line 4. |
Enter the total distributions received from this Coverdell ESA in 2004. Do not include amounts rolled over to
another Coverdell ESA within 60 days (only one rollover is allowed during any 12-month period). |
|
Also, do not include excess contributions that were distributed with the related earnings (or less any loss) before the first
day of the sixth
month of the tax year following the year of the contributions. |
Line 7. |
Enter the total value of this Coverdell ESA as of December 31, 2004, plus any outstanding rollovers contributed
to the account after 2003, but before the end of the 60-day rollover period. A statement should be sent to you by January
31, 2005, for this Coverdell
ESA showing the value on December 31, 2004. |
|
A rollover is a tax-free withdrawal from one Coverdell ESA that is contributed to another Coverdell ESA. An outstanding
rollover is any amount withdrawn within 60 days before the end of 2004 (November 2 through December 31) that was rolled over after
December 31,
2004, but within the 60-day rollover period. |
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