Publication 970 (2007), Tax Benefits for Education

IRS Resources

7. Coverdell Education Savings Account (ESA)

Table of Contents

Introduction

If your modified adjusted gross income (MAGI) is less than $110,000 ($220,000 if filing a joint return), you may be able to establish a Coverdell ESA to finance the qualified education expenses of a designated beneficiary. For most taxpayers, MAGI is the adjusted gross income as figured on their federal income tax return.

There is no limit on the number of separate Coverdell ESAs that can be established for a designated beneficiary. However, total contributions for the beneficiary in any year cannot be more than $2,000, no matter how many accounts have been established. See Contributions, later.

This benefit applies not only to higher education expenses, but also to elementary and secondary education expenses.

What is the tax benefit of the Coverdell ESA. Contributions to a Coverdell ESA are not deductible, but amounts deposited in the account grow tax free until distributed.

If, for a year, distributions from an account are not more than a designated beneficiary's qualified education expenses at an eligible educational institution, the beneficiary will not owe tax on the distributions. See Tax-Free Distributions, later.

Table 7-1 summarizes the main features of the Coverdell ESA.

What Is a Coverdell ESA

A Coverdell ESA is a trust or custodial account created or organized in the United States only for the purpose of paying the qualified education expenses of the designated beneficiary of the account.

When the account is established, the designated beneficiary must be under age 18 or a special needs beneficiary.

To be treated as a Coverdell ESA, the account must be designated as a Coverdell ESA when it is created.

The document creating and governing the account must be in writing and must satisfy the following requirements.

The trustee or custodian must be a bank or an entity approved by the IRS.
The document must provide that the trustee or custodian can only accept a contribution that meets all of the following conditions.
1. The contribution is in cash.
2. The contribution is made before the beneficiary reaches age 18, unless the beneficiary is a special needs beneficiary.
3. The contribution would not result in total contributions for the year (not including rollover contributions) being more than $2,000.
Money in the account cannot be invested in life insurance contracts.
Money in the account cannot be combined with other property except in a common trust fund or common investment fund.
The balance in the account generally must be distributed within 30 days after the earlier of the following events.
1. The beneficiary reaches age 30, unless the beneficiary is a special needs beneficiary.
2. The beneficiary's death.

As of this printing, regulations defining a “special needs beneficiary” have not been released. If available, the definition will be included in Publication 553, Highlights of 2007 Tax Changes, which will be issued in early 2008.

Table 7-1. Coverdell ESA at a Glance

Do not rely on this table alone. It provides only general highlights. See the text for definitions of terms in bold type and for
more complete explanations.

Question	Answer
What is a Coverdell ESA?	A savings account that is set up to pay the qualified education expenses of a designated beneficiary.
Where can it be established?	It can be opened in the United States at any bank or other IRS-approved entity that offers Coverdell ESAs.
Who can have a Coverdell ESA?	Any beneficiary who is under age 18 or is a special needs beneficiary.
Who can contribute to a Coverdell ESA?	Generally, any individual (including the beneficiary) whose modified adjusted gross income for the year is less than $110,000 ($220,000 in the case of a joint return).
Are distributions tax free?	Yes, if the distributions are not more than the beneficiary's adjusted qualified education expenses for the year.

Qualified Education Expenses

Generally, these are expenses required for the enrollment or attendance of the designated beneficiary at an eligible educational institution. For purposes of Coverdell ESAs, the expenses can be either qualified higher education expenses or qualified elementary and secondary education expenses.

Designated beneficiary. This is the individual named in the document creating the trust or custodial account to receive the benefit of the funds in the account.

Eligible Educational Institution

For purposes of Coverdell ESAs, an eligible educational institution can be either an eligible postsecondary school or an eligible elementary or secondary school.

Eligible postsecondary school. This is any college, university, vocational school, or other postsecondary educational institution eligible to participate in a student aid program administered by the Department of Education. It includes virtually all accredited public, nonprofit, and proprietary (privately owned profit-making) postsecondary institutions. The educational institution should be able to tell you if it is an eligible educational institution.

Certain educational institutions located outside the United States also participate in the U.S. Department of Education's Federal Student Aid (FSA) programs.

Eligible elementary or secondary school. This is any public, private, or religious school that provides elementary or secondary education (kindergarten through grade 12), as determined under state law.

Qualified Higher Education Expenses

These are expenses related to enrollment or attendance at an eligible postsecondary school. As shown in the following list, to be qualified, some of the expenses must be required by the school and some must be incurred by students who are enrolled at least half-time. Contributions to qualified tuition programs can be qualified education expenses (see item (4) in the following list).

The following expenses must be required for enrollment or attendance of a designated beneficiary at an eligible postsecondary school.
1. Tuition and fees.
2. Books, supplies, and equipment.
Expenses for special needs services needed by a special needs beneficiary must be incurred in connection with enrollment or attendance at an eligible postsecondary school. (See Caution below.)
Expenses for room and board must be incurred by students who are enrolled at least half-time (defined below).

The expense for room and board qualifies only to the extent that it is not more than the greater of the following two amounts.
1. The allowance for room and board, as determined by the school, that was included in the cost of attendance (for federal financial aid purposes) for a particular academic period and living arrangement of the student.
2. The actual amount charged if the student is residing in housing owned or operated by the school.
Any contribution to a qualified tuition program (QTP) must be on behalf of the designated beneficiary of the Coverdell ESA. In the case of a change in beneficiary, this is a qualified expense only if the new beneficiary is a family member of that designated beneficiary. (See chapter 8, Qualified Tuition Program (QTP).)

Half-time student. A student is enrolled “at least half-time” if he or she is enrolled for at least half the full-time academic work load for the course of study the student is pursuing, as determined under the standards of the school where the student is enrolled.

Qualified Elementary and Secondary Education Expenses

These are expenses related to enrollment or attendance at an eligible elementary or secondary school. As shown in the following list, to be qualified, some of the expenses must be required or provided by the school. There are special rules for computer-related expenses.

The following expenses must be incurred by a designated beneficiary in connection with enrollment or attendance at an eligible elementary or secondary school.
1. Tuition and fees.
2. Books, supplies, and equipment.
3. Academic tutoring.
4. Special needs services for a special needs beneficiary. (See Caution below.)
The following expenses must be required or provided by an eligible elementary or secondary school in connection with attendance or enrollment at the school.
1. Room and board.
2. Uniforms.
3. Transportation.
4. Supplementary items and services (including extended day programs).
The purchase of computer technology, equipment, or Internet access and related services is a qualified elementary and secondary education expense if it is to be used by the beneficiary and the beneficiary's family during any of the years the beneficiary is in elementary or secondary school. (This does not include expenses for computer software designed for sports, games, or hobbies unless the software is predominantly educational in nature.)

Contributions

Any individual (including the designated beneficiary) can contribute to a Coverdell ESA if the individual's modified adjusted gross income (MAGI) (defined later under Contribution Limits) for the year is less than $110,000. For individuals filing joint returns, that amount is $220,000.

Organizations, such as corporations and trusts, can also contribute to Coverdell ESAs. There is no requirement that an organization's income be below a certain level.

Contributions must meet all of the following requirements.

They must be in cash.
They cannot be made after the beneficiary reaches age 18, unless the beneficiary is a special needs beneficiary, and
They must be made by the due date of the contributor's tax return (not including extensions).

Contributions can be made to one or several Coverdell ESAs for the same designated beneficiary provided that the total contributions are not more than the contribution limits (defined later) for a year.

Contributions can be made, without penalty, to both a Coverdell ESA and a QTP in the same year for the same beneficiary.

Table 7-2 summarizes many of the features of contributing to a Coverdell ESA.

Table 7-2. Coverdell ESA Contributions at a Glance

Do not rely on this table alone. It provides only general highlights. See the text for more complete explanations.

Question	Answer
Are contributions deductible?	No.
Why should someone contribute to a Coverdell ESA?	Earnings on the account grow tax free until distributed.
What is the annual contribution limit per designated beneficiary?	$2,000 for each designated beneficiary.
What if more than one Coverdell ESA has been opened for the same designated beneficiary?	The annual contribution limit is $2,000 for each beneficiary, no matter how many Coverdell ESAs are set up for that beneficiary.
What if more than one individual makes contributions for the same designated beneficiary?	The annual contribution limit is $2,000 per beneficiary, no matter how many individuals contribute.
Can contributions other than cash be made to a Coverdell ESA?	No.
When must contributions stop?	No contributions can be made to a beneficiary's Coverdell ESA after he or she reaches age 18, unless the beneficiary is a special needs beneficiary.

When contributions considered made. Contributions made to a Coverdell ESA for the preceding tax year are considered to have been made on the last day of the preceding year. They must be made by the due date (not including extensions) for filing your return for the preceding year.

For example, if you make a contribution to a Coverdell ESA in February 2008, and you designate it as a contribution for 2007, you are considered to have made that contribution on December 31, 2007.

Contribution Limits

There are two yearly limits:

One on the total amount that can be contributed for each designated beneficiary in any year, and
One on the amount that any individual can contribute for any one designated beneficiary for a year.

Limit for each designated beneficiary. For 2007, the total of all contributions to all Coverdell ESAs set up for the benefit of any one designated beneficiary cannot be more than $2,000. This includes contributions (other than rollovers) to all the beneficiary's Coverdell ESAs from all sources. Rollovers are discussed under Rollovers and Other Transfers, later.

Example.

When Maria Luna was born in 2006, three separate Coverdell ESAs were set up for her, one by her parents, one by her grandfather, and one by her aunt. In 2007, the total of all contributions to Maria's three Coverdell ESAs cannot be more than $2,000. For example, if her grandfather contributed $2,000 to one of her Coverdell ESAs, no one else could contribute to any of her three accounts. Or, if her parents contributed $1,000 and her aunt $600, her grandfather or someone else could contribute no more than $400. These contributions could be put into any of Maria's Coverdell ESA accounts.

Limit for each contributor. Generally, you can contribute up to $2,000 for each designated beneficiary for 2007. This is the most you can contribute for the benefit of any one beneficiary for the year, regardless of the number of Coverdell ESAs set up for the beneficiary.

Example.

The facts are the same as in the previous example except that Maria Luna's older brother, Edgar, also has a Coverdell ESA. If their grandfather contributed $2,000 to Maria's Coverdell ESA in 2007, he could also contribute $2,000 to Edgar's Coverdell ESA.

Reduced limit. Your contribution limit may be reduced. If your modified adjusted gross income (MAGI) (defined below) is between $95,000 and $110,000 (between $190,000 and $220,000 if filing a joint return), the $2,000 limit for each designated beneficiary is gradually reduced (see Figuring the limit, later). If your MAGI is $110,000 or more ($220,000 or more if filing a joint return), you cannot contribute to anyone's Coverdell ESA.

Modified adjusted gross income (MAGI). For most taxpayers, MAGI is adjusted gross income (AGI) as figured on their federal income tax return.

MAGI when using Form 1040A. If you file Form 1040A, your MAGI is the AGI on line 22 of that form.

MAGI when using Form 1040. If you file Form 1040, your MAGI is the AGI on line 38 of that form, modified by adding back any:

Foreign earned income exclusion,
Foreign housing exclusion,
Exclusion of income for bona fide residents of American Samoa, and
Exclusion of income for bona fide residents of Puerto Rico.

You can use Worksheet 7-1 to figure your MAGI.

Worksheet 7-1. MAGI for a Coverdell ESA

1.	Enter your adjusted gross income (Form 1040, line 38)		1.
2.	Enter your foreign earned income exclusion and/or housing exclusion (Form 2555, line 45, or Form 2555-EZ, line 18)	2.
3.	Enter the amount of income from Puerto Rico that you are excluding	3.
4.	Enter the amount of income from American Samoa that you are excluding (Form 4563, line 15)	4.
5.	Add the amounts on lines 2, 3, and 4		5.
6.	Add the amounts on lines 1 and 5. This is your modified adjusted gross income		6.

MAGI when using Form 1040NR. If you file Form 1040NR, your MAGI is the AGI on line 36 of that form.

MAGI when using Form 1040NR-EZ. If you file Form 1040NR-EZ, your MAGI is the AGI on line 10 of that form.

Figuring the limit. To figure the limit on the amount you can contribute for each designated beneficiary, multiply $2,000 by a fraction. The numerator (top number) is your MAGI minus $95,000 ($190,000 if filing a joint return). The denominator (bottom number) is $15,000 ($30,000 if filing a joint return). Subtract the result from $2,000. This is the amount you can contribute for each beneficiary. You can use Worksheet 7-2 to figure the limit on your contributions.

Worksheet 7-2. Coverdell ESA Contribution Limit

1.	Maximum contribution	1.	$2,000
2.	Enter your modified adjusted gross income (MAGI) for purposes of figuring the contribution limit to a Coverdell ESA (see definition or Worksheet 7-1 earlier)	2.
3.	Enter $190,000 if married filing jointly; $95,000 for all other filers	3.
4.	Subtract line 3 from line 2. If zero or less, enter -0- on line 4, skip lines 5 through 7, and enter $2,000 on line 8	4.
5.	Enter $30,000 if married filing jointly; $15,000 for all other filers	5.
	Note.If the amount on line 4 is greater than or equal to the amount on line 5, stop here. You are not allowed to contribute to a Coverdell ESA for 2007.
6.	Divide line 4 by line 5 and enter the result as a decimal (rounded to at least 3 places)	6.	.
7.	Multiply line 1 by line 6	7.
8.	Subtract line 7 from line 1	8.
Note:The total Coverdell ESA contributions from all sources for the designated beneficiary during the tax year may not exceed $2,000.

Example.

Paul, who is single, had MAGI of $96,500 for 2007. Paul can contribute up to $1,800 in 2007 for each beneficiary, as shown in the illustrated Worksheet 7-2.

Worksheet 7-2. Coverdell ESA Contribution Limit—Illustrated

1.	Maximum contribution	1.	$2,000
2.	Enter your modified adjusted gross income (MAGI) for purposes of figuring the contribution limit to a Coverdell ESA (see definition or Worksheet 7-1 earlier)	2.	96,500
3.	Enter $190,000 if married filing jointly; $95,000 for all other filers	3.	95,000
4.	Subtract line 3 from line 2. If zero or less, enter -0- on line 4, skip lines 5 through 7, and enter $2,000 on line 8	4.	1,500
5.	Enter $30,000 if married filing jointly; $15,000 for all other filers	5.	15,000
	Note.If the amount on line 4 is greater than or equal to the amount on line 5, stop here. You are not allowed to contribute to a Coverdell ESA for 2007.
6.	Divide line 4 by line 5 and enter the result as a decimal (rounded to at least 3 places)	6.	.100
7.	Multiply line 1 by line 6	7.	200
8.	Subtract line 7 from line 1	8.	1,800
Note: The total Coverdell ESA contributions from all sources for the designated beneficiary during the tax year may not exceed $2,000.

Additional Tax on Excess Contributions

The beneficiary must pay a 6% excise tax each year on excess contributions that are in a Coverdell ESA at the end of the year. Excess contributions are the total of the following two amounts.

Contributions to any designated beneficiary's Coverdell ESA for the year that are more than $2,000 (or, if less, the total of each contributor's limit for the year, as discussed earlier).
Excess contributions for the preceding year, reduced by the total of the following two amounts:
1. Distributions (other than those rolled over as discussed later) during the year, and
2. The contribution limit for the current year minus the amount contributed for the current year.

Exceptions. The excise tax does not apply if excess contributions made during 2007 (and any earnings on them) are distributed before the first day of the sixth month of the following tax year (June 1, 2008, for a calendar year taxpayer).

However, you must include the distributed earnings in gross income for the year in which the excess contribution was made. You should receive Form 1099-Q, Payments From Qualified Education Programs (Under Sections 529 and 530), from each institution from which excess contributions were distributed. Box 2 of that form will show the amount of earnings on your excess contributions. Enter the amount of earnings on line 21 of Form 1040. For more information, see Taxable Distributions, later.

The excise tax does not apply to any rollover contribution.

Note.

Contributions made in one year for the preceding taxable year are considered to have been made on the last day of the preceding year.

Example.

In 2006, Greta's parents and grandparents contributed a total of $2,300 to Greta's Coverdell ESA— an excess contribution of $300. Because Greta did not withdraw the excess before June 1, 2007, she had to pay an additional tax of $18 (6% × $300) when she filed her 2006 tax return.

In 2007, excess contributions of $500 were made to Greta's account, however, she withdrew $250 from that account to use for qualified education expenses. Using the steps shown under Additional Tax on Excess Contributions, Greta figures the excess contribution in her account at the end of 2007 as follows.

(1)	$500 excess contributions made in 2007
+ (2)	$300 excess contributions in ESA at end of 2006
- (2a)	$250 distribution during 2007
	$550 excess at end of 2007	× 6%=$33

If Greta limits 2008 contributions to $1,450 ($2,000 maximum allowed - $550 excess contributions from 2007), she will not owe any additional tax in 2008 for excess contributions.

Figuring the additional tax. You figure this excise tax in Part V, Form 5329, Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts. Report the additional tax on Form 1040, line 60.

Rollovers and Other Transfers

Assets can be rolled over from one Coverdell ESA to another or the designated beneficiary can be changed. The beneficiary's interest can be transferred to a spouse or former spouse because of divorce.

Rollovers

Any amount distributed from a Coverdell ESA is not taxable if it is rolled over to another Coverdell ESA for the benefit of the same beneficiary or a member of the beneficiary's family (including the beneficiary's spouse) who is under age 30. This age limitation does not apply if the new beneficiary is a special needs beneficiary.

An amount is rolled over if it is paid to another Coverdell ESA within 60 days after the date of the distribution.

Do not report qualifying rollovers (those that meet the above criteria) anywhere on Form 1040. These are not taxable distributions.

Members of the beneficiary's family. For these purposes, the beneficiary's family includes the beneficiary's spouse and the following other relatives of the beneficiary.

Son, daughter, stepchild, foster child, or a descendant of any of them.
Brother, sister, stepbrother, or stepsister.
Father or mother or ancestor of either.
Stepfather or stepmother.
Son or daughter of a brother or sister.
Brother or sister of father or mother.
Son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, or sister-in-law.
The spouse of any individual listed above.
First cousin.

Example.

When Aaron graduated from college last year he had $5,000 left in his Coverdell ESA. He wanted to give this money to his younger sister, who was still in high school. In order to avoid paying tax on the distribution of the amount remaining in his account, Aaron contributed the same amount to his sister's Coverdell ESA within 60 days of the distribution.

Only one rollover per Coverdell ESA is allowed during the 12-month period ending on the date of the payment or distribution.

Changing the Designated Beneficiary

The designated beneficiary can be changed to a member of the beneficiary's family (defined above). There are no tax consequences if, at the time of the change, the new beneficiary is under age 30 or a special needs beneficiary.

Example.

Assume the same situation as in the last example. Instead of closing his Coverdell ESA and paying the distribution into his sister's Coverdell ESA, Aaron could have instructed the trustee of his account to simply change the name of the beneficiary on his account to that of his sister.

Transfer Because of Divorce

If a spouse or former spouse receives a Coverdell ESA under a divorce or separation instrument, it is not a taxable transfer. After the transfer, the spouse or former spouse treats the Coverdell ESA as his or her own.

Example.

In their divorce settlement, Peg received her ex-husband's Coverdell ESA. In this process, the account was transferred into her name. Peg now treats the funds in this Coverdell ESA as if she were the original owner.

Distributions

The designated beneficiary of a Coverdell ESA can take a distribution at any time. Whether the distributions are tax free depends, in part, on whether the distributions are equal to or less than the amount of adjusted qualified education expenses (defined next) that the beneficiary has in the same tax year.

See Table 7-3 (on the next page) for highlights.

Adjusted qualified education expenses. To determine if total distributions for the year are more than the amount of qualified education expenses, reduce total qualified education expenses by any tax-free educational assistance. Tax-free educational assistance includes:

The tax-free part of scholarships and fellowships (see chapter 1),
Veterans' educational assistance (see chapter 1),
Pell grants (see chapter 1),
Employer-provided educational assistance (see chapter 11), and
Any other nontaxable (tax-free) payments (other than gifts or inheritances) received as educational assistance.

The amount you get by subtracting tax-free educational assistance from your total qualified education expenses is your adjusted qualified education expenses.

Tax-Free Distributions

Generally, distributions are tax free if they are not more than the beneficiary's adjusted qualified education expenses for the year. Do not report tax-free distributions (including qualifying rollovers) on your tax return.

Taxable Distributions

A portion of the distributions is generally taxable to the beneficiary if the distributions are more than the beneficiary's adjusted qualified education expenses for the year.

Excess distribution. This is the part of the total distribution that is more than the beneficiary's adjusted qualified education expenses for the year.

Earnings and basis. You will receive a Form 1099-Q for each of the Coverdell ESAs from which money was distributed in 2007. The amount of your gross distribution will be shown in box 1. For 2007, instead of dividing the gross distribution between your earnings (box 2) and your basis (already-taxed amount) (box 3), the payer or trustee may report the fair market value (account balance) of the Coverdell ESA as of December 31, 2007. This will be shown in the blank box below boxes 5 and 6.

Table 7-3. Coverdell ESA Distributions at a Glance

Do not rely on this table alone. It provides only general highlights. See the text for definitions of terms in bold type and for
more complete explanations.

Question	Answer
Is a distribution from a Coverdell ESA to pay for a designated beneficiary's qualified education expenses tax free?	Generally, yes, to the extent the amount of the distribution is not more than the designated beneficiary's adjusted qualified education expenses.
After the designated beneficiary completes his or her education at an eligible educational institution, can amounts remaining in the Coverdell ESA be distributed?	Yes. Amounts must be distributed when the designated beneficiary reaches age 30, unless he or she is a special needs beneficiary. Also, certain transfers to members of the beneficiary's family are permitted.
Does the designated beneficiary need to be enrolled for a minimum number of courses to take a tax-free distribution?	No.

Figuring the Taxable Portion of a Distribution

The taxable portion is the amount of the excess distribution that represents earnings that have accumulated tax free in the account. Figure the taxable portion for 2007 as shown in the following steps.

Multiply the amount distributed by a fraction. The numerator is the basis (contributions not previously distributed) at the end of 2006 plus total contributions for 2007 and the denominator is the value (balance) of the account at the end of 2007 plus the amount distributed during 2007.
Subtract the amount figured in (1) from the total amount distributed during 2007. This is the amount of earnings included in the distribution(s).
Multiply the amount of earnings figured in (2) by a fraction. The numerator is the adjusted qualified education expenses paid during 2007 and the denominator is the total amount distributed during 2007.
Subtract the amount figured in (3) from the amount figured in (2). This is the amount the beneficiary must include in income.

The taxable amount must be reported on Form 1040 or Form 1040NR, line 21.

Example.

You received an $850 distribution from your Coverdell ESA, to which $1,500 had been contributed before 2007. There were no contributions in 2007. This is your first distribution from the account, so your basis in the account on December 31, 2006, was $1,500. The value (balance) of your account on December 31, 2007, was $950. You had $700 of adjusted qualified education expenses (AQEE) for the year. Using the steps above, figure the taxable portion of your distribution as follows.

	1.	$850 (distribution)	×	$1,500 basis + $0 contributions $950 value + $850 distribution
		=$708 (basis portion of distribution)

	2.	$850 (distribution)-$708 (basis portion of distribution)
		=$142 (earnings included in distribution)

	3.	$142 (earnings)	×	$700 AQEE $850 distribution
		=$117 (tax-free earnings)

	4.	$142 (earnings included in distribution)-$117 (tax-free earnings)
		=$25 (taxable earnings)

You must include $25 in income as distributed earnings not used for qualified education expenses. Report this amount on Form 1040, line 21, listing the type and amount of income on the dotted line.

Worksheet 7-3, at the end of this chapter, can help you figure your adjusted qualified education expenses, how much of your distribution must be included in income, and the remaining basis in your Coverdell ESAs.