ESA Brochures & Forms:
"Upon the subject of education... I view it as the most important subject which we as a people may be engaged in."
— Abraham Lincoln
Education Savings Accounts
Named Education IRAs when first established in 1998, these accounts were renamed Coverdell Education Savings Accounts (ESA) in July 2001. (Despite the original name, education IRAs had nothing to do with retirement). The ESA is a tax-favored account for the purpose of saving for education expenses. ESAs allow contributions for any child under age 18, and tax-free distributions for a broad variety of education expenses up until age 30.
A Coverdell Education Savings Account (ESA) is a tax-exempt trust created in the United States for the sole purpose of paying the qualified education expenses of the designated beneficiary. No contribution may be accepted by the ESA after the beneficiary attains age 18. Annual contributions to the ESA may not exceed $2,000 (eligible contributions may be less if the taxpayer’s income exceeds certain thresholds). All contributions must be in cash. As with an IRA, an ESA will lose its tax-exempt status if it is used in a prohibited transaction.
Aggregate contributions that may be made by all contributors to one or more ESAs established on behalf of any particular beneficiary are limited to $2,000 for each year. Corporations, tax-exempt organizations and other entities may make contributions to an unlimited number of parties’ ESAs, so long as they do not contribute more than $2,000 to any particular beneficiary.
The maximum income that joint tax return filers can report and still make a full contribution to an ESA is $190,000. For incomes up to $220,000, lesser contributions can be made. For single filers, the full contribution income limit is $95,000, phasing out at $110,000.
Contributions to an ESA may be made up to April 15th (the tax return due date, not including extensions) for a contribution to apply to the preceding year. Any contribution to an ESA is treated as a gift from the contributor to the beneficiary at the time of the contribution, meaning annual contributions are eligible for the gift tax exclusion and are excludable for purposes of the generation-skipping transfer tax.
A 6% excise applies to excess contributions, that is, those that are:
- More than a total of $2,000 per designated beneficiary per year;
- Made in a year when the contributor’s adjusted gross income tops the limits for income eligibility;
- Contributed to a designated beneficiary who is 18 years of age or older;
- Made in violation of applicable rollover rules.
Excess contributions, if corrected in a timely manner, will avoid the penalty.
Distributions from ESAs are tax-free provided that they are used to pay the beneficiary’s qualified education expenses. Tuition, fees, books, supplies, and equipment required for attendance at an eligible educational institution are qualified expenses. The term includes room and board expenses, if (1) the beneficiary is enrolled in a program leading to a recognized educational credential and (2) the student carries at least one-half the normal full-time work load for a chosen course of study.
New rules allow you to use the Education Savings Account to pay for elementary and secondary expenses at private, public, or religious schools. This includes academic tutoring, computer technology or equipment (such as internet services), room and board, transportation, uniforms, supplemental items and services (including extended day care), and special needs services in the case of a special needs beneficiary. Additional exceptions are available to special needs students. Qualified education expenses are reduced by the amount of any scholarships or financial aid received.
Taxpayers may claim the HOPE Scholarship Credit or the Lifetime Learning Credit in the same year that a tax-free distribution is made from an ESA. However, the distributions cannot cover the same education expense.
Because contributions to ESAs are treated as gifts, distributions from the accounts are made only to beneficiaries. Distributions of ESAs are excludable from gross income to the extent that the distribution does not exceed the qualified education expenses incurred by the beneficiary during the year in which the distribution is made. Distributions are tax exempt regardless of whether the beneficiary attends an education institution on a full-time or half-time basis.
Distributions in amounts greater than allowed tax-free are taxed under IRS Code Section 72 annuity rules. There is an additional 10% tax imposed on any taxpayer who receives an ESA distribution that is includable in gross income, with certain exceptions.
Amounts remaining in an eduction savings account may be rolled over into another ESA for the education of another beneficiary in the beneficiary’s family. Similarly, any change in beneficiary does not constitute a distribution if the new beneficiary is a member of the family of the original beneficiary. A person’s family members are determined under IRS Code Section 529(e)(2). Alternatively, assets remaining in the ESA may be distributed to the original beneficiary who must include the earnings component of the distribution in income and pay a 10% penalty.
The balance remaining in an ESA must be distributed within 30 days after a beneficiary reaches age 30. Also, distribution of the account balance of a deceased beneficiary must be made within 30 days after the death of a beneficiary under age 30. Where such a distribution is required, the balance at the close of the 30-day period is deemed to be distributed at that time.
The person who controls the ESA is the "responsible party" as named in the account agreement. The responsible party typically is the parent or guardian of the beneficiary.
HOPE Scholarship Credit / American Opportunity Credit
While not part of the Education Savings Account, the HOPE Scholarship Credit (renamed American Opportunity Credit in 2009) does interrelate with the ESA. Taxpayers may be able to claim a HOPE Scholarship/American Opportunity Education Credit against their federal income taxes. The credit is claimed for the qualified tuition and related expenses of each student in the taxpayer’s family who is enrolled at least half-time in one of the first four years of post secondary education and who is enrolled in a program leading to a recognized educational credential. The maximum credit a taxpayer may claim for a taxable year is $2,500 multiplied by the number of students in the family who meet the entrollment criteria. The amount a taxpayer may claim is gradually reduced for taxpayers with modified adjusted gross incomes above $80,000 ($160,000 for joint filers), and phased out at $90,000 ($180,000 for joint filers). See IRS Publication 970 for more information.
Lifetime Learning Credit
Similarly, the Lifetime Learning Credit also interrelates with the ESA. Taxpayers may be able to claim a nonrefundable Lifetime Learning Credit against their federal income taxes. The credit is claimed for the qualified tuition and related expenses of each student in the taxpayer’s family who is enrolled in eligible education institutions. Unlike the HOPE Scholarship/ American Oppotunity Credit, students are not required to be enrolled at least half-time in one of the first two years of post secondary education. The amount that may be claimed as a credit is equal to 20% of the taxpayer’s first $10,000 of out-of-pocket qualified tuition and other expenses for all the students in the family. The amount a taxpayer may claim is gradually reduced for taxpayers with modified adjusted gross incomes above $50,000 ($100,000 for joint filers), and phased out at $60,000 ($120,000 for joint filers).