Coverdell ESA Form Explained

Have you checked out the sticker price of a college education lately? You might want to sit down first (a box of tissues is also advised). According to 2012-2013 numbers from the U.S. Department of Education, the average price for a single year at a private four-year college (tuition, fees, room and board) was around $35,000 [source: NCES].

But what if your little ones won't be entering college until 2021? Is the cost of college expected to go down, or at least — please — slow down? Hold on to that tissue box, pal. A private four-year college is projected to cost around $50,000 for tuition, fees, room and board per year [source: Ally]. That's actually not so hard to believe, as some Ivy League schools already charge more than that in 2014.

The good news is that the federal government recognizes the critical importance of education and has established a number of college savings plans with built-in tax benefits. One of those plans, established by the Taxpayer Relief Act of 1997, is called the Coverdell Education Savings Account (ESA).

Coverdell ESAs share a lot in common with 529 college savings accounts offered by individual states. The most important similarity between Coverdell ESAs and 529 plans is that they are both double tax-free. Money in these education investment accounts grows tax-free and all payments from the accounts are distributed tax-free as long as the money is used for a qualified educational expense. Contributions to both types of accounts, however, are not tax-deductible.

There are some important differences between Coverdell ESAs and 529 plans, though, including the following [source: Saving for College]:

Coverdell ESAs have an annual contribution limit of $2,000 for each beneficiary; 529s have much higher limits — over $300,000 in many cases.
Contributions to a Coverdell ESA phase out if you make more than $95,000 ($190,000 for joint filers); 529s have no income restrictions.
Money in a Coverdell ESA can be used to pay for both college and certain K-12 expenses. 529 funds can only be used for college.
Coverdell ESAs offer more control over investment options, while 529 plans are managed funds.
Remaining funds in a Coverdell ESA are distributed to the beneficiary at age 30, while 529 plans typically don't have any age restrictions.

To claim the full tax benefits of a Coverdell ESA, you need to open an account with an IRS-approved bank or financial institution. In turn, that bank or trust company must file a report with the IRS every tax year detailing how much money has been contributed to the account. That report is called the Form 5498-ESA. Keep reading to learn how to read the 5498-ESA and how to make sense of the IRS fine print.

Coverdell ESA Beneficiaries

The IRS Form 5498-ESA is what's known as an information return. Other examples of information returns include the Form 5498 for IRA contributions and the 1099-MISC for money paid to an independent contractor. One function of an information return is for a bank or business to report the movement of money to the IRS. In the case of the 1099-MISC, it helps the IRS track the income of self-employed workers. Form 5498-ESA helps the IRS make sure that no more than $2,000 is deposited in a beneficiary's name in the same tax year.

The second function of an information return is to tell the beneficiary — also known as the payee — that a payment has been reported to the IRS. That's why there are two copies of each Form 5498-ESA: "Copy A" for the IRS and "Copy B" for the beneficiary. The trustee of the Coverdell ESA — a bank or other financial institution issuing the account — is responsible for completing and mailing out both copies of the Form 5498-ESA.

Who is the beneficiary of a Coverdell ESA? It's the student, not the person, who is contributing money to the student's account. For the student to qualify as a beneficiary, a Coverdell ESA must be established before the student reaches 18 years old (or older if the student has special needs). The account must be designated as a Coverdell from the start, not rolled over from another kind of savings account [source: IRS].

There are several boxes on the IRS Form 5498-ESA reserved for information about the beneficiary, known here as the "recipient":

Recipient's name
Full mailing address
Social Security number
Account number

The account number of the Coverdell ESA helps the IRS keep track of multiple Coverdell accounts that name the same person as a recipient. Remember, there is no limit to the number of accounts tied to the same beneficiary, only that the total value of all annual contributions to that beneficiary not exceed $2,000 [source: IRS].

Next, we'll talk about the IRS definitions of contributions and rollovers.

Coverdell ESA Contributions and Rollovers

For the IRS, the most important function of the Form 5498-ESA is to keep track of how much money has been contributed to each beneficiary's accounts. That's why the two most important boxes on the Form 5498-ESA are box numbers one and two: "Coverdell ESA contributions" and "Rollover contributions."

Only regular ESA contributions are counted toward the total limit of $2,000 per beneficiary per tax year. Rollover contributions do not count toward the limit and can come in several forms [source: IRS]:

Trustee-to-trustee – in this kind of rollover, money from one bank's Coverdell ESA is transferred directly to another bank's Coverdell ESA. As long as it's done within 60 days of withdrawing the money, no income tax is triggered.
Trustee-to-trustee transfers are tax-free even when both accounts aren't in the same name. As long as both beneficiaries are family members, no income tax is owed.
Certain U.S. savings bonds can also be cashed out and rolled over into a Coverdell ESA without incurring income tax.
Family members of a fallen soldier who receive a military death gratuity can roll over any portion of the death benefit to a Coverdell ESA without income tax consequences.

What happens if too much money is contributed to the same beneficiary's Coverdell ESA? If he or she receives more than $2,000 in a single tax year, the excess contributions are subject to a 6 percent excise. One way to avoid the 6 percent penalty is to withdraw the excess amount before June of the following year and use it toward educational expenses. However, the excess amount will still be included in your gross income for the year [source: IRS].

Note that there are actually two contribution limits [source: IRS]:

A $2,000 limit on contributions to any individual beneficiary
A $2,000 limit on how much any individual can contribute to any single beneficiary

This is important because both limits can be lowered even further if either the beneficiary or the contributor earns too much money. The contribution limit phases out at a modified adjusted gross income of between $95,000 and $110,000 for single filers and $190,000 and $220,000 for joint filers. Using the IRS phase-out formulas, if a married couple earns $200,000, they can only contribute $1,300 to each child's Coverdell ESA. If that same child somehow earns $97,000, then the total contributions to his or her Coverdell ESA cannot exceed $1,734 a year. (The IRS prorates the contribution amounts, based on where the income falls in the phase-out range – if it's right in the middle, for instance, you could only contribute 50 percent of the maximum or $1,000).

Next we'll explore the potential tax implications of Coverdell ESA distributions.

Coverdell ESA Distributions

The whole point of a Coverdell ESA is to save money for education expenses — both for college and K-12 — and cash it in tax-free. When the beneficiary of a Coverdell ESA (the student) withdraws money from the savings account, that's called a distribution. Distributions are tax-free if they meet both of the following criteria [source: IRS]:

The money must be used to pay for qualified educational expenses.
The total of all distributions cannot exceed the total amount of educational expenses incurred in the tax year.

So what, exactly, is a qualified educational expense? The IRS breaks these down into two categories: Qualified Higher Education Expenses and Qualified Elementary and Secondary Education Expenses.

For the higher education expenses, the beneficiary of the Coverdell ESA must be enrolled in an eligible school at least half-time. Expenses that qualify for tax-free distributions include tuition, fees, books, supplies, equipment, room and board, and expenses related to special needs services [source: IRS].

The list of tax-free elementary and secondary education expenses is a little longer and includes tuition, fees, books, supplies, equipment, room and board, special needs services, academic tutoring, transportation, uniforms, and even computer equipment and Internet access, as long as its used for academic purposes [source: IRS].

Remember that one of the criteria for tax-free Coverdell distributions is that they can't be greater than the total amount of educational expenses. There's a catch, though. If you receive any other form of financial assistance, you need to subtract those amounts from your educational expenses first. So if a year of college costs $30,000, but you receive $20,000 in tax-free scholarships, Pell grants, veteran's grants or employer-provided educational assistance, then your total educational expenses for the year are reduced to $10,000.

You are allowed to also claim the American opportunity or lifetime learning tax credit in the same year that you take the Coverdell ESA, as long as the same expenses are not used for both benefits.

If a Coverdell ESA beneficiary withdraws too much money from the account, the excess distribution is taxable. Check out the complete formula for calculating the tax liability — warning: it involves fractions — in the Taxable Distributions section of IRS Publication 970, Tax Benefits for Education.

If you take a distribution from a Coverdell ESA, you will receive a second information return called an IRS Form 1099-Q. The form will show much money you withdrew from your account during the tax year. Use this amount to compare with your educational expenses when figuring what is taxable and — fingers crossed — what isn't.

Lots More Information

Author's Note: Coverdell ESA Form Explained

As a parent of three young children, I spend considerable time worrying about how we're going to pay for their college education. I'm grateful that there are savings accounts available — Coverdell ESAs and state-run 529 plans — that allow my wife and I (and our generous parents) to set aside some money that will grow tax-free and be earmarked exclusively for education expenses. I also try to comfort myself with the fact that no one pays full tuition at any college or university, and that financial aid packages are designed to make up the difference between the full bill and what a family can afford to pay.

But I'm also disappointed that my kids will likely enter the "real" world saddled with student loan debt. Who knows, though, but the time my first kid enters college — a decade away, still — the whole system might be replaced by free MOOCS. A poor dad can dream, can't he?

Sources

IRS. "Coverdell Education Savings Accounts (ESA)." Publication 970, Tax Benefits for Education. 2013 (Dec. 12, 2014) http://www.irs.gov/publications/p970/ch07.html
IRS. "General Instructions for Certain Information Returns" (Dec. 12, 2014) http://www.irs.gov/instructions/i1099gi/ar02.html#d0e1316
IRS. "Instructions for Form 5498-ESA" (Dec. 12, 2014) http://www.irs.gov/instructions/i5498e/ar02.html
IRS. "Topic 310: Coverdell Education Savings Accounts" (Dec. 12, 2014) http://www.irs.gov/taxtopics/tc310.html
National Center for Education Statistics. "Fast Facts: Tuition costs of colleges and universities." 2013 (Dec. 12, 2014) http://nces.ed.gov/fastfacts/display.asp?id=76
Saving for College. "Compare Savings Options" (Dec. 12, 2014) http://www.savingforcollege.com/compare_savings_options/?assigned_to%5B%5D=0&assigned_to%5B%5D=1&hiddenField=vehicles&mode=Submit