Coverdell Education Savings Accounts (CESAs) were created in 1997 to allow qualified educational expenses incurred by a “designated beneficiary” to be paid for with a tax-free distribution. Many individuals on whose behalf these accounts were established are now at the age of using the CESA for educational expenses. This article will cover the basics you need to know.
Any individual can establish a CESA for an eligible individual, referred to as a “designated beneficiary”. Unless a special needs exception applies, a designated beneficiary must be younger than age 18 when the initial CESA is established. As a designated beneficiary is younger than age 18 at the time of initial account establishment, the individual that establishes the CESA names a “responsible individual” to manage the account (i.e., authorize distributions, complete rollovers and transfers, direct investments, change the designated beneficiary if allowed by the CESA agreement, etc.). The responsible individual is generally a parent or legal guardian; however, the responsible individual may designate a “successor responsible individual” in the event the original responsible individual passes away or becomes incapacitated. Additionally, a death beneficiary may be named.
The CESA application contains an “Optional Provisions” section. This is where the individual that establishes a CESA selects whether or not the responsible individual can change the designated beneficiary, and selects who will have control of the account when the designated beneficiary reaches the age of majority - the designated beneficiary, or the responsible individual. A CESA custodian/trustee will need to verify who has authorization to take distributions after the beneficiary reaches the age of majority, since the answer is found on the application.
An individual may contribute to as many CESAs as he/she wants to for any given tax year. But CESA contributions for a designated beneficiary are limited to no more than $2,000 per year from all contribution sources and are not deductible. Contributions may be made by other entities also; for example, a tax exempt or charitable organization.
The deadline for making CESA contributions is the contributor’s tax-filing due date, excluding extensions.
Transfers and rollovers
A CESA may be transferred to a new or existing CESA at a different financial organization. This includes transferring a designated beneficiary’s CESA to a family member’s CESA, considering the family member is younger than age 30. Keep in mind that unless transferring to another family member within the same financial organization, CESA-to-CESA transfers are reportable.
A distribution from a CESA may be rolled over to a new or existing CESA. The 60-day rule and one per 12-month rollover rule apply.
As mentioned earlier, the primary benefit of a CESA is that distributions are tax free for qualified educations expenses. This includes qualified elementary and secondary education expenses, qualified higher education expenses, and qualified state tuition program contributions. It is not a requirement that a distribution check be made payable to an educational institution directly; it can be made payable to the designated beneficiary.
Nondeductible regular contributions are always tax and penalty free when distributed, regardless of what the distribution is used for. The portion of the distribution attributed to earnings is only tax and penalty free when used for a qualified educational expense. However, a distribution of earnings due to death (unless internally transferred to a CESA of a family member), disability, or any unused amount due to the designated beneficiary’s receipt of a scholarship are taxable, yet penalty free.
A distribution of any remaining assets in a CESA is required within 30 days of the designated beneficiary’s 30th birthday. An exception is made for a designated beneficiary with special needs.
Financial organizations must report CESA regular, rollover, and transfer contributions on IRS Form 5498-ESA, Coverdell ESA Contribution Information. Contributions are reported in the designated beneficiary’s name and tax identification number.
Distributions, including transfers, must be reported on IRS Form 1099-Q, Payments From Qualified Education Programs (Under Sections 529 and 530). If possible, a CESA custodian/trustee should make an attempt to track basis and earnings and report the appropriate amounts on the 1099-Q accordingly. However, this is not required. Distributions are reported in the designated beneficiary’s name and tax identification number. The CESA custodian/trustee is not required to verify what the distributed amount is used for to properly report the distribution, with the exception of removing an excess contribution, disability, death, or a prohibited transaction.
CESAs are unique because there are multiple parties involved, including an individual that initially funds and establishes an account, a responsible individual (may be same as establisher), a designated beneficiary, and a CESA custodian/trustee. Financial organizations need to know the role of each party. The custodian/trustee is responsible for properly establishing, administering, and reporting CESA related transactions. It seems there is more activity in these accounts recently, and it may be because more designated beneficiaries are reaching college age. See IRS Publication 970, Tax Benefits For Education for more information.