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Publication 970
Tax Benefits for Education

For use in preparing 2002 Returns

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.

  1. 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).
  2. Excess contributions for the preceding year, reduced by the total of the following two amounts:
    1. Withdrawals (other than those rolled over as discussed later) made 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   The excise tax does not apply if excess contributions made during 2002 (and any earnings on them) are withdrawn before the first day of the sixth month of the following tax year (June 1, 2003, for a calendar year taxpayer).

The withdrawn earnings must be included in gross income for the year in which the excess contribution was made.

The excise tax does not apply to any rollover contribution.

How to figure.   You figure this excise tax in Part V, Form 5329, Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts. You report it on line 58, Form 1040.

Worksheet 5-2. 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 5-1 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 2002.     
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.

Rollovers and Other Transfers

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

Rollovers

Any amount withdrawn from a Coverdell ESA and rolled over to another Coverdell ESA for the benefit of the same beneficiary or a member of the beneficiary's family who is under age 30 is not taxable. An amount is rolled over if it is paid to another Coverdell ESA within 60 days after the date of the withdrawal.

Members of the beneficiary's family.   The amounts in a Coverdell ESA can be transferred tax free to the designated beneficiary's spouse or any of the following other members of the beneficiary's family.

  1. Son or daughter or descendant of son or daughter.
  2. Stepson or stepdaughter.
  3. Brother, sister, stepbrother, or stepsister.
  4. Father or mother or ancestor of either.
  5. Stepfather or stepmother.
  6. Son or daughter of a brother or sister.
  7. Brother or sister of father or mother.
  8. Son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, or sister-in-law.
  9. The spouse of any individual listed above.
  10. First cousin.

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

Changing the Designated Beneficiary

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

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.

Withdrawals

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

See Table 5-3 for highlights.

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.

Table 5-3.  Coverdell ESA Withdrawals At a Glance
Question Answer
Is a withdrawal 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 withdrawal 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, may amounts remaining in the Coverdell ESA be withdrawn? Yes. Amounts must be withdrawn 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 withdrawal? No.

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

  • Scholarships that are excluded from gross income,
  • Veterans' educational assistance,
  • Pell grants,
  • Employer-provided educational assistance, and
  • Any other nontaxable payments (other than gifts, bequests, or inheritances) received for education expenses.

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

Tax-Free Withdrawals

Generally, withdrawals are tax free if they are not more than the beneficiary's adjusted qualified education expenses for the year.

Taxable Withdrawals

Generally, a portion of the withdrawals is taxable to the beneficiary if the withdrawals are more than the beneficiary's adjusted qualified education expenses for the year.

Figuring the Taxable Portion of a Withdrawal

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

  1. Multiply the amount withdrawn by a fraction. The numerator is the total contributions in the account and the denominator is the total balance in the account before the withdrawal(s).
  2. Subtract the amount figured in (1) from the total amount withdrawn during the year. This is the amount of earnings included in the withdrawal(s).
  3. Multiply the amount of earnings figured in (2) by a fraction. The numerator is the adjusted qualified education expenses paid during the year and the denominator is the total amount withdrawn during the year.
  4. 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 line 21, Form 1040.

Example.   You receive an $850 distribution from a Coverdell ESA to which $1,500 has been contributed. The balance in the account before the withdrawal was $1,800. You had $700 of adjusted qualified education expenses for the year. Using the steps above, you figure the taxable portion of your withdrawal as follows.

  1. $850 × ($1,500 ÷ $1,800) = $708 (basis portion of distribution)
  2. $850 - $708 = $142 (earnings included in distribution)
  3. $142 × ($700 ÷ $850) = $117 (tax-free earnings)
  4. $142 - $117 = $25 (taxable earnings)

You must include $25 in income as withdrawn earnings not used for qualified education expenses.

Worksheet 5-3, 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 already-taxed amount (basis) in your Coverdell ESAs.

Coordination With Hope and Lifetime Learning Credits

In prior years, the designated beneficiary was required to waive tax-free treatment of the withdrawal from a Coverdell ESA before a Hope or lifetime learning credit could be claimed. Beginning in 2002, no such waiver is required. An education credit can be claimed in the same year the beneficiary takes a tax-free distribution from a Coverdell ESA, as long as the same expenses are not used for both benefits. Therefore, after the beneficiary reduces qualified higher education expenses by tax-free educational benefits, he or she must further reduce them by the expenses taken into account in determining an education credit.

Example.   Derek Green had $4,200 of qualified higher education expenses for 2002, his first year in college. He paid his college expenses from the following sources.

  Partial tuition scholarship (excluded from  income on his tax return) $1,500  
  Coverdell ESA withdrawal 1,000  
  Gift from parents 500  
  Earnings from part-time job 1,200  

parents claimed a $1,500 Hope credit on their tax return.

Before Derek can determine the taxable portion of his withdrawal, he must reduce his total qualified higher education expenses.

  Total qualified higher education expenses $4,200  
  Minus: Tax-free educational benefits - 1,500  
  Minus: Expenses taken into account in  figuring Hope credit - 2,000  
  Equals: Adjusted qualified higher education  expenses $  700  

taxable. The balance in Derek's account before the $1,000 withdrawal was $2,800, to which $2,500 had been contributed. Using the four steps outlined earlier, Derek figures the taxable portion of his withdrawal as shown below.

  1. $1,000 × ($2,500 ÷ $2,800) = $893 (basis)
  2. $1,000 - $893 = $107 (earnings)
  3. $107 × ($700 ÷ $1,000) = $75 (tax-free earnings)
  4. $107 - $75 = $32 (taxable earnings)

Derek must include $32 in income. This represents withdrawn earnings not used for qualified higher education expenses.

Coordination With Qualified Tuition Program (QTP) Withdrawals

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 more 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. The following two examples illustrate possible allocations.

Example 1.   In 2002, Beatrice graduated from high school and began her first semester of college. That year, she had $1,000 of qualified elementary and secondary education expenses (QESEE) and $3,000 of qualified higher education expenses (QHEE). To pay these expenses, Beatrice withdrew $800 from her Coverdell ESA and $4,200 from her QTP. No one claimed Beatrice as a dependent, nor was she eligible for an education credit. She did not receive any tax-free educational assistance in 2002. Beatrice must allocate her qualified education expenses between the two withdrawals.

 1) Beatrice knows that tax-free treatment will be avail- able if she applies her $800 Coverdell ESA with- drawal toward her $1,000 of qualified expenses for high school. The qualified expenses are greater than the withdrawal, making the $800 Coverdell ESA with- drawal tax free.
 2) Next, Beatrice matches her $4,200 QTP withdrawal to her $3,000 of QHEE, and finds she has an excess QTP withdrawal of $1,200 ($4,200 QTP - $3,000 QHEE). She cannot use the extra $200 of high school expenses (from (1) above) against the QTP withdrawal because those expenses do not qualify a QTP for tax-free treatment.
 3) Finally, Beatrice figures the taxable and tax-free portions of her QTP withdrawal based on QHEE of $3,000. (See Figuring the Taxable Portion, in chapter 6, for more information.)

Example 2.   Assume the same facts as in Example 1, except that Beatrice withdrew $1,800 from her Coverdell ESA and $3,200 from her QTP. In this case, she allocates her qualified education expenses as follows.

 1) Using the same reasoning as in Example 1, Beatrice matches $1,000 of her Coverdell ESA withdrawal to her $1,000 of QESEE - she has $800 of her with- drawal remaining.
 2) Because higher education expenses can also qualify a Coverdell ESA withdrawal for tax-free treatment, Beatrice allocates her $3,000 QHEE between the remaining $800 Coverdell ESA and the $3,200 QTP withdrawals ($4,000 total).
  $3,000 expenses × $800 ESA withdrawal = $  600  
  $4,000 total withdrawal  
  $3,000 expenses × $3,200 QTP withdrawal = $2,400  
  $4,000 total withdrawal  
 3) Beatrice then figures the taxable part of her Cover- dell ESA withdrawal based on qualified education expenses of $1,600 ($1,000 QESEE + $600 QHEE), and the taxable part of her QTP withdrawal based on QHEE of $2,400. For Coverdell ESA information, see Figuring the Taxable Portion of a Withdrawal, earlier in this chapter. For QTP information, see Figuring the Taxable Portion, in chapter 6.

TAXTIP: These examples show two types of allocation between withdrawals from a Coverdell ESA and a QTP. However, you do not have to allocate your expenses in the same way. You may use any reasonable method.

Additional Tax on Taxable Withdrawals

Generally, if you receive a taxable withdrawal, you also must pay a 10% additional tax on the amount included in income.

Exceptions.   The 10% additional tax does not apply to withdrawals described in the following list.

  1. Paid to a beneficiary (or to the estate of the designated beneficiary) on or after the death of the designated beneficiary.
  2. Made because the designated beneficiary is disabled. A person is considered to be disabled if he or she shows proof that he or she cannot do any substantial gainful activity because of his or her physical or mental condition. A physician must determine that his or her condition can be expected to result in death or to be of long-continued and indefinite duration.
  3. Made because the designated beneficiary received:
    1. A qualified scholarship excludable from gross income,
    2. Veterans' educational assistance,
    3. Employer-provided educational assistance, or
    4. Any other nontaxable payments (other than gifts, bequests, or inheritances) received for education expenses.
  4. Included in income only because the qualified education expenses were taken into account in determining the Hope or lifetime learning credit.
  5. A return of an excess 2002 contribution (and any earnings on it) made before June 1, 2003. The withdrawn earnings must be included in gross income for the year in which the excess contribution was made.

Exception (3) applies only to the extent the withdrawal is not more than the scholarship, allowance, or payment.

Use Part II of Form 5329, Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts, to figure any additional tax. Report the amount on Form 1040, line 58.

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