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.