ESA Introduction

ESA In Brief

ESA Q's and A's

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Coverdell Education Savings Accounts

Note: The information and related links on this page were accurate as of January 2002. But Congress regularly amends the tax code. Be sure to secure updated information.

Related PDF Documents (January 2002):

CAPE's Consolidation of IRS Guidance on ESAs
(20 pages of relevant excerpts from the IRS documents listed below - January 2002)
Publication 970: Tax Benefits for Higher Education (44 pp.)
Publication 553: Highlights of 2001 Tax Changes (25 pp.)
Instructions for Form 8606 (8 pp.) Form 8606 (2 pp.)

Introduction

January 2002 - The school choice movement made major progress in 2001 when Congress approved and President Bush signed a breakthrough measure of tax relief to help with the costs of a child's education in a private, including religious, elementary or secondary school. Although the relief is relatively modest--essentially amounting to tax-free interest on savings earmarked for education--its historical significance is unmistakable. Another brick has been removed from the wall that separates parents from the freedom to choose their children's schools.

Named after the late Paul Coverdell, the Georgia senator who fought valiantly and tirelessly for the measure, education savings accounts (ESAs) bring some important improvements to the education IRAs they replace. Coverdell ESAs have an annual contribution limit of $2,000 (compared to their predecessor's $500) and the funds can be used not only for college costs, but also for expenses in grades K-12. Families with children in public and private schools can use the accounts to pay for things like books, supplies, after-school programs, tuition, tutoring, and even home computers. Although contributions to an ESA are not tax deductible (they weren't for an education IRA either), the interest that accumulates is tax free, and withdrawals are not subject to taxation if used for qualified expenses. A noteworthy component of the program allows third parties, including relatives, friends, corporations, unions, and organizations, to contribute to an individual's ESA.

Like all tax-related programs, Coverdell ESAs come with rules from the Internal Revenue Service. The rules are scattered throughout three publications:

  • Publication 970: Tax Benefits for Higher Education
  • Publication 553: Highlights of 2001 Tax Changes
  • Instructions for Form 8606: Nondeductible IRAs and Coverdell ESAs

Form 8606 is used to report disbursements from education savings accounts.

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ESAs in Brief

A Coverdell ESA is a trust or custodial account established to pay the qualified education expenses of a designated beneficiary. Up to $2,000 annually can be contributed to the account.

The buildup of interest within an account is tax free, and neither the principal nor interest is taxable upon withdrawal if used for a qualified education expense.

Qualified education expenses include tuition, fees, books, supplies, and equipment at a public, private, or religious elementary or secondary school or college.

Entities such as corporations, charitable organizations, and foundations can contribute to a student's account.

Individual taxpayers with modified adjusted gross incomes under $95,000 and married taxpayers with incomes under $190,000 can make the maximum allowable annual contribution to an ESA. The allowable contribution is gradually reduced at higher levels of income.

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Q's and A's

How do the accounts work?

Parents and other taxpayers, including corporations, organizations, and a child's relatives, can contribute collectively up to $2,000 each year to a Coverdell education savings account (formerly known as an education individual retirement account or education IRA) established for a particular beneficiary. The buildup of interest within the account is tax free, and neither the principal nor interest is taxable upon withdrawal if used for a qualified educational expense.

What is a qualified educational expense?

As defined in the new tax legislation, the term includes certain expenses associated with higher education that are specified in current law, and also includes expenses for elementary and secondary education, including "tuition, fees, academic tutoring, special needs services in the case of a special needs beneficiary, books, supplies, and other equipment which are incurred in connection with the enrollment or attendance of the designated beneficiary of the trust as an elementary or secondary school student at a public, private, or religious school." Allowable K-12 expenses also include "room and board, uniforms, transportation, and supplementary items and services (including extended day programs)," as well as "computer technology or equipment (as defined in section 170(e)(6)(F)(i)) or Internet access and related services, if such technology, equipment, or services are to be used by the beneficiary and the beneficiary's family during any of the years the beneficiary is in school." Computer expenses, however, can not include "expenses for computer software designed for sports, games, or hobbies unless the software is predominantly educational in nature."

What taxpayers are eligible to make contributions to an ESA?

Individual taxpayers with modified adjusted gross incomes under $95,000 and married taxpayers filing a joint return with incomes under $190,000 may make the maximum allowable annual contribution to an ESA. The contribution level is phased out for individual taxpayers with annual incomes between $95,000 and $110,000, and for married taxpayers with incomes between $190,000 and $220,000. Individuals and married couples with incomes above the respective phase-out levels are not allowed to make contributions to an ESA.

Corporations and other entities (including tax-exempt organizations) are also permitted to make contributions to an ESA, regardless of the annual income of the corporation or entity.

What is the cut-off date for contributions to an ESA?

In general, individual taxpayers can make contributions for a given year up to April 15 of the following year.

How does the new ESA law differ from its predecessor?

There are two main differences. Under the old law the annual contribution limit to an ESA was $500; under the new law it is $2,000. Under the old law withdrawals could be used only for higher education expenses; under the new law withdrawals can also be used for K-12 expenses.

When did the changes to the ESA law take effect?

The new provisions became effective for taxable years beginning January 1, 2002.

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