Publication 970
Tax Benefits for Education

For use in preparing 2002 Returns

5. Coverdell Education Savings Account (ESA) - Formerly Education IRA

Important Changes for 2002

Maximum contribution increased.   Beginning in 2002, the most you can contribute each year per beneficiary to a Coverdell ESA is increased from $500 to $2,000. See Contribution Limits, under Contributions, for more information.

Income limits increased for married couples filing a joint return.   If you are married and filing a joint return for 2002, your contribution limit is not reduced if your modified adjusted gross income (MAGI) is $190,000 or less. Your contribution limit is gradually reduced (phased out) if your MAGI is more than $190,000 but less than $220,000. If your MAGI is $220,000 or more, you cannot contribute to a Coverdell ESA. This is an increase from the 2001 limits of $150,000 and $160,000. See Contribution Limits, under Contributions, for more information.

Contribution due date extended.   The final date on which you can make contributions to a Coverdell ESA for any year has been extended from the last day of the year to the due date of your return for that year (not including extensions). If you are a calendar year taxpayer, you generally have until April 15, 2003, to make your contribution for the 2002 tax year.

Qualified education expenses expanded.   Beginning in 2002, qualified education expenses include certain elementary and secondary education expenses, as well as certain expenses for special needs students. For more information, see Qualified Education Expenses, under What Is a Coverdell ESA.

Limit on room and board changed.   The limit on the amount that is considered reasonable for room and board expenses has changed. You must contact the educational institution for its qualified room and board costs. For more information, see Qualified higher education expenses, under Higher Education.

Age limitations waived for special needs beneficiaries.   Beginning in 2002, you can make contributions to a Coverdell ESA for a special needs beneficiary after his or her 18th birthday. Also, you can leave assets in a Coverdell ESA set up for a special needs beneficiary after he or she reaches age 30. For more information, see What Is a Coverdell ESA.

Coverdell ESA coordinated with Hope and lifetime learning credits.    Beginning in 2002, you may be able to claim a Hope or lifetime learning credit in the same year in which the beneficiary takes a tax-free withdrawal from a Coverdell ESA. However, you cannot use the expenses on which the credit is based to figure the taxable portion of the withdrawal from the Coverdell ESA. See Coordination With Hope and Lifetime Learning Credits, under Taxable Withdrawals, for more information.

Any part of the withdrawal from the Coverdell ESA that is taxable only because an education credit was claimed is not subject to the 10% additional tax on taxable withdrawals.

Coverdell ESA coordinated with qualified tuition program (QTP).    Beginning in 2002, if a designated beneficiary takes withdrawals from both a Coverdell ESA and a QTP in the same year, and the total withdrawn is greater than the beneficiary's adjusted qualified higher education expenses, those expenses must be allocated between the withdrawal from the Coverdell ESA and the withdrawal from the QTP before figuring how much of each withdrawal is taxable. For more information, see Coordination With Qualified Tuition Program (QTP) Withdrawals, under Taxable Withdrawals.

Definition of family members expanded.    Beginning in 2002, for purposes of rollovers and changes of designated beneficiaries, the definition of family members is expanded to include first cousins of the designated beneficiary. For more information, see Rollovers and Other Transfers.

Contributions to both Coverdell ESA and QTP allowed in same year.   Beginning in 2002, you can make contributions, without penalty, to a Coverdell ESA even if contributions are also being made to a QTP on behalf of the same designated beneficiary. Before 2002, contributions to the Coverdell ESA that were made in the same year as contributions to a QTP were subject to the additional tax on excess contributions.

Important Change for 2003

Deadline for withdrawing excess contributions changed.   There will be no additional tax on excess contributions if the excess (and earnings on that amount) is withdrawn before the beginning of the sixth month following the year of the contribution. Generally, a calendar year taxpayer will have until May 31, 2003, to withdraw an excess contribution for 2002. Previously, excess contributions (and earnings) had to be withdrawn by the due date (including extensions) for filing the beneficiary's tax return or, if no return was required, by April 15 of the following year. See Additional Tax on Taxable Withdrawals for more information.

Introduction

You may be able to establish a Coverdell ESA to finance the qualified education expenses of a designated beneficiary. Until July 26, 2001, this type of account was called an education individual retirement arrangement (or Education IRA).

Contributions to a Coverdell ESA are not deductible, but amounts deposited in the account grow tax free until withdrawn. Generally, you can contribute up to $2,000 cash for a year per beneficiary. In the case of a special needs beneficiary, the beneficiary can be 18 or older.

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.

If, for a year, withdrawals 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 withdrawals. See Tax-Free Withdrawals, later.

Table 5-1 summarizes the main features of the Coverdell ESA.

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.

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.

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

Qualified Education Expenses

Generally, these are expenses required for the enrollment or attendance of the designated beneficiary at an eligible school. Beginning in 2002, in addition to certain higher education expenses, certain expenses for education at elementary and secondary schools can also be qualified education expenses.

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

Elementary and Secondary Education

Eligible elementary and secondary schools and qualified expenses are defined below.

Eligible 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 elementary and secondary education expenses.   To be qualified, elementary and secondary education expenses must be related to enrollment or attendance at an eligible school, as shown below.

1. The following expenses must be incurred by a designated beneficiary in connection with enrollment or attendance at an eligible school.
   1. Tuition and fees.
   2. Books, supplies, and equipment.
   3. Academic tutoring.
   4. Special needs services for a special needs beneficiary. (See Caution on the next page.)
2. The expenses listed below must be required or provided by an eligible school in connection with attendance or enrollment.
   1. Room and board.
   2. Uniforms.
   3. Transportation.
   4. Supplementary items and services (including extended day programs).
3. 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 school. (This does not include expenses for computer software designed for sports, games, or hobbies unless the software is predominantly educational in nature.)

Higher Education

Eligible postsecondary schools and qualified expenses are shown below.

Eligible educational institution.   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.

Qualified higher education expenses.   To be qualified, each higher education expense must meet certain criteria, as shown below.

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

   The expense for room and board qualifies only to the extent that it does not exceed the greater of the following two amounts.

   1. The allowance for room and board, as determined by the eligible educational institution, 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 eligible educational institution.
4. Any contribution to a qualified tuition program (QTP) must be on behalf of the designated beneficiary of the Coverdell ESA. (See chapter 6, 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.

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 2002 Tax Changes, which will be issued in early 2003.

Contributions

Any individual (including the designated beneficiary for whose benefit the account is established) can contribute to a Coverdell ESA if the individual's modified adjusted gross income (MAGI) 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.

1. They must be in cash.
2. They cannot be made after the beneficiary reaches age 18, unless the beneficiary is a special needs beneficiary, and
3. 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.

Beginning in 2002, contributions can be made, without penalty, to both a Coverdell ESA and a QTP in the same year for the same beneficiary.

Table 5-2 (see next page) summarizes many of the features of contributing to a 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.

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

MAGI when using Form 1040.   If you file Form 1040, your MAGI is the AGI on line 36 of that form, modified by adding back any:

1. Foreign earned income exclusion,
2. Foreign housing exclusion,
3. Exclusion of income for bona fide residents of American Samoa, and
4. Exclusion of income from Puerto Rico.

You can use Worksheet 5-1 to figure your MAGI.

Contribution Limits

There are two yearly limits:

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

Limit for each designated beneficiary.   For 2002, 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 2001, three separate Coverdell ESAs were set up for her, one by her parents, one by her grandfather, and one by her aunt. In 2002, 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 2002. 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 2002, he could also contribute $2,000 to Edgar's Coverdell ESA.

Reduced limit.   Your contribution limit may be reduced. If your MAGI (defined earlier) 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, next). 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.

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

contribute for each beneficiary. You can use Worksheet 5-2 to figure the limit on your contributions.

Example.   Paul, who is single, had MAGI of $96,500 for 2002. Paul can contribute up to $1,800 in 2002 for each beneficiary, as shown in the illustrated Worksheet 5-2.

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