The Coverdell Education Savings Account is a specialized account for saving for K-12 and college education expenses, similar in some ways to 529 college savings plans.
However, there are a number of important differences. One is that contributions to Coverdell education savings accounts are limited to $2,000 per year from all sources, as opposed to 529 college savings plans. 529 college savings plans have no limit on annual contributions, other than the annual gift tax exclusion, and allow lump sum contributions up to five times the annual limit using the five-year average of the gift tax.
Can You Get Around the $2,000 Contribution Limit on Coverdell Education Savings Accounts? If so, how?
What is a Coverdell Education savings account?
Coverdell Education Savings Accounts, formerly known as Education IRAs, are used to save for the beneficiary’s education costs, including elementary, middle, and high school fees and college fees.
The definition of qualified education expenses for a Coverdell education savings account is broader for K-12 spending than in a 529 plan. The definition of qualified higher education expenditure is the same.
Income is accumulated on a tax-deferred basis. Benefits to pay for qualified education expenses are tax-free. The profit portion of an unqualified distribution is taxed as income, plus a 10% tax penalty.
A Coverdell Education Savings Account is reported as an account custodian asset on the Free Application for Federal Student Aid (FAFSA). The guardian is usually the parent. Qualifying benefits from a Coverdell Education Savings Account are not reported as income on the FAFSA.
Coverdell education savings accounts offer a wider selection of investment options than 529 college savings plans. The money can be invested in individual stocks and bonds, not just a limited number of mutual funds.
Contributions to a Coverdell Education Savings Account are made in cash with after-tax money.
Coverdell Contribution Limits
Total contributions to all Coverdell education savings accounts for a beneficiary from all sources are limited to $2,000 per year. This requires the contributors to coordinate their contributions to avoid exceeding the $2,000 annual contribution limit.
The $2,000 contribution limit for each contributor is tapered based on the contributor’s income. It is reduced for contributors with adjusted adjusted gross income (AGI) from $190,000 to $220,000 for married joint filing and half that for single submitters. Taxpayers who file separately married returns are not eligible to contribute to a Coverdell Education Savings Account. Income reduction does not change and is not adjusted for inflation.
Excess contributions are subject to an annual tax of 6% until the money is paid out (not as part of a rollover). Excess premiums in the previous year can be reduced by the unused portion of the current year’s premium limit. If the overpaid premium is paid before 1 June, the excise duty for that year does not apply.
Contributions for the previous tax year can be made until the normal due date for the contributor’s federal income tax return.
Contributions to a Coverdell education savings account must end when the beneficiary reaches the age of 18, unless the beneficiary is a special needs beneficiary.
In addition, the Coverdell Education Savings Account must be fully disbursed by the time the beneficiary reaches the age of 30, unless the beneficiary is a special needs beneficiary. One can get around this limitation by changing the beneficiary to another beneficiary who is under the age limit or by transferring the money to a 529 college savings plan.
How to Get Around the Coverdell Contribution Income Phasing Out?
The income reduction on premiums can be circumvented by having the contributor give the money to the beneficiary in cash. The beneficiary can then deposit the money into their own Coverdell education savings account.
Another option is to contribute to a Coverdell education savings account through an organization, such as a company or trust. Such organizations are not subject to income restrictions.
How to get around the $2000 Coverdell contribution limit?
There are several ways to circumvent the annual premium limits on a Coverdell education savings account.
Change the beneficiary
One method to get around the $2,000 contribution limit is to change the beneficiary in another beneficiary’s Coverdell savings account.
For example, if a sibling does not attend college and does not need the money in their Coverdell education savings account for education expenses, the beneficiary can be changed on the account without violating the new beneficiary’s $2,000 annual contribution limit.
If a parent has money left over in their own Coverdell education savings account, they can change the beneficiary from themselves to their child, if the parent is under the age of 30 at the time of the child’s birth.
Rollover contributions (including from US savings bonds)
Rollover contributions are not subject to the annual contribution limit of $2,000 per 26 USC 530(b)(1)(A), so one could transfer the proceeds of qualified US savings bonds to a Coverdell education savings account to meet the annual contribution limit. of $2,000 to get around. (One cannot transfer money from a 529 college savings plan or prepaid tuition plus to a Coverdell education savings account.) The 6% excess tax excise tax does not apply to revolving contributions [26 USC 4973(e)(2)(B)]†
Qualifying US Savings Bonds include Series EE or Series I US Savings Bonds issued in 1990 or later.
Rollover contributions are defined as including a rollover from another Coverdell education savings account [26 USC 530(d)(5)]military death tips [26 USC 530(d)(9)(A)] and a rollover from a qualified US Savings Bond [26 USC 135(c)(2)(C)]†
The language at 26 USC 135(c)(2)(C) treats a contribution from Qualifying U.S. Savings Bonds to a Qualifying Tuition Program (529 Subscription or Prepaid Tuition Plan) or Coverdell Education Savings Account as a qualified higher education expense. It uses the term ‘contribution’ and not the term ‘rollover contribution’.
However, the instructions for IRS Form 5498-ESA refer to a contribution from a qualified US Savings Bond as a rollover: “A rollover may be made from certain US Savings Bonds or another Coverdell ESA.” In addition, the manner in which such rollovers are reported on IRS Form 8815 does not enforce a $2,000 contribution limit. IRS guidelines regarding Coverdell education savings accounts, such as Section 21.6.5 of the IRS Revenue Manual and Section 4.19.3 of the Internal Revenue Manual, do not state that the $2,000 contribution limit applies to Education Savings rollovers. Bond program.
So a rollover contribution from a qualified U.S. savings bond to a Coverdell education savings account is likely not subject to the $2,000 contribution limit.
However, there are practical limits to the number of qualified U.S. savings bonds that can be rolled over into a Coverdell education savings account.
Individuals can purchase up to $10,000 in Series EE and $10,000 in Series I US Savings Bonds for themselves each year through TreasuryDirect. They can also purchase up to $10,000 of each type of bond per recipient as a gift. The limits are per Social Security Number, whether the bonds were purchased for yourself or received as a gift. Married taxpayers can purchase U.S. savings bonds each up to these limits, plus up to $5,000 in paper Series I U.S. savings bonds using their federal income tax refund. Thus, the child’s parents can each purchase or receive a combination of $10,000 in Series EE and $10,000 in Series I U.S. Savings Bonds, for a total of $20,000 each, plus up to $5,000 in additional Series I paper based bonds. of their federal income tax refund.
Interest on a qualified U.S. Savings Bond is tax-free if the proceeds are spent on qualifying higher education expenses (tuition and fees) or transferred to a 529 subscription, prepaid tuition plan, or Coverdell savings account for education, and taxpayer income is lower than certain income reductions. (The income reduction is $85,800 to $100,800 for single taxpayers in 2022 and $128,650 to $158,650 for married taxpayers filing federal income tax returns jointly. Married individuals filing separately are not eligible. The income reduction is adjusted annually for inflation. ) The owner of the bond must be at least 24 years old when the bond is issued for the interest to be tax-free.
To qualify for the tax-free interest benefit, the Coverdell education savings account must be in the same name as the bond owner, the spouse of the bond owner, or the dependent of the bond owner. This limits a grandparent’s ability to directly use a US Savings Bond to get around the $2,000 annual contribution limit. They should register the bond in the name of the child’s parent.
Series I and Series EE US Savings Bonds cannot be redeemed until they are 12 months old. If Series I and EE US Savings Bonds are redeemed before they are five years old, there is also an early redemption penalty of three months’ interest.
Of course, there are no limits on contributions to a 529 plan, other than the $16,000 annual gift tax exclusion in 2022 (with lump sum contributions of up to $80,000, though the average of five years of gift tax) and the total limits that range from $235,000. up to $542,000, depending on the state.
But some families prefer greater control over investment in education savings from Coverdell and the broader definition of qualified education expenses.
This post How to get around the $2000 Coverdell contribution limit?
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