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Education Tax Planning

This article will examine requirements for the Coverdell education accounts, contribution limits for these accounts and the tax treatment of distributions.

Code Sec.530 authorizes the Coverdell ESA as an education savings account and can be set up as a trust or custodial account for a designated beneficiary. In 2002 this program was expanded so that it can now be used to finance elementary and secondary education expenses.

There is no relationship requirement to open a Coverdell ESA, so you can designate a beneficiary child of your choice. The only requirement is the child has to be under the age of 18. So you could designate your child, a relative or just anybody, it does not matter.

There are contribution limits in place though. There is a $2,000 aggregate contribution limit per year on behalf of any designated beneficiary. This means that if more than $2,000 is contributed per child, the amount over $2,000 is treated as an excess contribution. So if you contribute $2,000 and someone else contributes $600, then $600 would be treated as an excess contribution. If by the due date of the reutrn the excess contribution has not been withdrawn, then there is a 6% penalty.

One other important note here is that all contributions must be made in cash. Property such as stocks is not allowed.

In addition to the above-mentioned rules, there are contribution limits on the contributor. You may make a full contribution only if your modified adjusted gross income (MAGI) is not more than $190,000 on a joint return, and $95,000 if you file a single return. If your MAGI is above these figures, then the contribution limit phase-outs for a joint return are between $190,000 and $220,000, and for a single return between $95,000 and $110,000.

Now that we discussed contribution rules for Coverdell ESAs, let us move on to the taxation rules.

The earnings of Coverdell ESA investments are not subject to tax when earned and distributions are excludable form income of the beneficiary, but only to the extent that they do not exceed qualified education expenses incurred during the year the distributions are made. The definition of qualified education expenses would be tuition, fees and room and board if the beneficiary is enrolled on an at least half-time basis. Room and board would mean the posted rate by the school, or if the student lives off campus (but not at home), then the amount is fixed at $2,500. As far as tuition goes, even part time attendance would make tuition a qualified higher education expense.

As I mentioned earlier, even elementary and secondary education expenses are include. This would include parochial school tuition and other expenses such as uniforms, transportation and extended day care programs. Also included is Computer technology expenses such as Internet service. On occasion a beneficiary might take a distribution for reasons other than education. If this should happen, then the portion of the distribution that represents earnings that have accumulated tax-free in the account would be taxable. A 10% penalty would also apply to such nonqualified distributions, with the following exceptions; disability, death or receipt of a scholarship by the beneficiary. Also an exception applies in the case of military service academy appointments.

Distributions may also be rolled over tax-free to another Coverdell ESA for the same beneficiary, or for certain other designated beneficiaries such as step-children, parents, siblings and their children, children of the beneficiary, step-parents, grandparents, and spouses of these people. There is a 60 day rollover period that applies.

If the desginated beneficiary has reached the age of 30, and the earning portion of a Coverdell ESA has not yet been used for qualified education expenses, and the earnings has not been rolled over to another elgible beneficary, then you would have to treat the remaining earning portion as a distribution.

Coverdell Education Savings Accounts can be used as an important part of your strategy to help with education expenses. They work best when used in conjunction with other opportunities and strategies allowed. I encourage you to educate yourself and then use all the available opportunities that fit your situation.

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