What to Do Now with Coverdell ESAs

Coverdell Education Savings Accounts, or ESAs, were greatly enhanced by the Economic Growth Tax Relief Act of 2001 as a tax-advantaged way to pay for education. However, the provisions in that act are set to expire at the end of 2010 and likely will not be extended; starting in 2010, old rules will again apply. These old rules are not very favorable; you may want to take action with respect to existing Coverdell ESAs before the end of the year.

Current Rules Contrasted with 2011 Rules

In 2010, you can add up to $2,000 each year to a beneficiary’s account until the beneficiary becomes 18 years old. Your modified adjusted gross income (MAGI), however, cannot exceed set limits. Joint filers have a limit that is double the limit for single filers (i.e., no marriage penalty). The funds grow on a tax-deferred basis. Investment options are usually limited. Coverdell ESA contributions can be made in addition to contributions to 529 plans (another savings vehicle for certain higher education costs).

The funds can be withdrawn tax free if used for education purposes-not only in higher education but also in primary and secondary school. Tax-free withdrawals can be made for tuition, books, and room and board, as well as computers and Internet access, transportation, school uniforms, and extended day programs.

After 2010, rules that existed prior to 2002 again take effect. This means that annual contributions are limited to $500. The marriage penalty on contributors again comes into play because joint filers no longer have double MAGI the limit for single filers. Contributions cannot be made to both Coverdell ESAs and 529 plans in the same year.

Withdrawals are restricted to higher education and can no longer be used for primary and secondary school costs.  Withdrawals are no longer tax free. Since contributions are made with after-tax dollars (no deduction is allowed), withdrawals are tax according to annuity rules; a portion of each withdrawal represents a return of capital (not taxable) and income on the contribution (taxable).

Actions in 2010

Those who have already funded Coverdell ESAs may want to take action now to avoid taxation in the future. There are a couple of options:

Roll over the Coverdell ESA into a 529 plan. This is a tax-free action that will permit access to funds for higher education in the future.

Spend down the balance before 2011. Consider using up funds in the Coverdell ESA before the end of this year. Again, they can be used on a wide variety of expenses for beneficiaries.

Contributions in 2010. You have until the due date of the 2010 return (April 15, 2011) to add funds to the Coverdell ESA. However, it may be wise to put the funds instead into other college savings vehicles:

• 529 plans. There are no income limits on contributions and no annual contribution limits set by the tax law (there are lifetime limits fixed by the plan).
• U.S. savings bonds. If you’re saving money to pay for college for yourself, your spouse, or your dependent and you’re at least 24 years old, you can use the money to buy bonds, Series EE or I. Then when you redeem the bonds to pay for certain higher education costs, the interest will be tax free.
• IRAs. You can use the money as an IRA contribution. Withdrawals from the IRA can be made to pay for tuition and fees for higher education. If the IRA contribution is tax deductible, then the withdrawal will be taxable. However, there is no early distribution penalty for taking funds from an IRA before age 59½ to pay for these higher education costs for yourself, you spouse or dependent.