Tax Treatment of Coverdell IRAs
The correct name for a Coverdell IRA is Coverdell Education Savings Account. Originally, Coverdell ESAs were called education IRAs and were very limited college savings plans. In 2002, changes in the rules expanded the scope of Coverdell ESAs. Today, a Coverdell ESA works much like a Roth IRA and is an effective investment tool for your education needs.
You can open and contribute to an ESA on behalf of any beneficiary younger than age 18. The beneficiary does not have to be your child or even be related to you. Total annual contributions are limited to $2,000, but this money can be put into the account by family, friends, and even organizations such as employers or civic groups. Contributions are not tax-deductible and can be made only until the beneficiary turns 18. If a child is a special needs student, the age limit is waived and contributions may be made at any age.
Investment earnings are not taxable while they remain in a Coverdell ESA. In addition, withdrawals are not subject to income taxes as long as they do not exceed qualified education expenses for primary, secondary or postsecondary schooling. Qualified expenses include tuition, fees, books and other costs that are not covered by scholarships or grants. You can use these tax-free ESA funds to buy a computer for a student to use, for example.
Any money withdrawn from a Coverdell ESA that is more than the qualified expenses is fully taxable and is normally subject to an additional 10 percent penalty tax. The beneficiary is liable for these taxes. The penalty tax may be waived if the excess withdrawal occurred because the beneficiary received a scholarship, dies or is disabled.
All of the money in a Coverdell ESA is supposed to be used by the time the beneficiary reaches age 30. The exception is when the beneficiary is a special needs student, in which case there is no age limit. Money remaining in the account after age 30 becomes taxable and is subject to the 10 percent penalty tax as well. However, you can change the beneficiary of the account to another person who is between the ages of 18 and 30 and so avoid creating this tax liability.
Based in Atlanta, Georgia, W D Adkins has been writing professionally since 2008. He writes about business, personal finance and careers. Adkins holds master's degrees in history and sociology from Georgia State University. He became a member of the Society of Professional Journalists in 2009.