Don't Mess With Taxes

Ways to pay for college get lots of attention. But if your kids are younger, there's also a tax-saving way to pay for the many educational expenses that pop up during grades K-12.

With a Coverdell Education Savings Account, or ESA, you can put up to $2,000 a year into a separate account for each kid. The accounts are established by an adult, with the child named as the account's beneficiary.

Coverdell ESAs, renamed for the late U.S. Senator Paul Coverdell who championed the savings option, used to be called education IRAs. That original appellation was in large part because you can open and contribute to a Coverdell ESA for the prior tax year though the April filing deadline.

Unlike some IRA contributions, however, there's no possible tax deduction. But you do get a tax break.

Coverdell ESA earnings accumulate tax-free. The account's distributions remain tax-free as long as they are used to pay for the school costs, both college level and well before then, of the kid who is named as account beneficiary.

Covering pre-college costs: That's right. Unlike many Internal Revenue Code education tax breaks, the use of Coverdell funds also includes qualified costs incurred from kindergarten classes and through high school diploma day.

That means if your elementary school age son or daughter needs a computer to complete homework assignments, you can use the youngster's Coverdell money to buy it. And yes, I know some folks who have bought their kindergarten kids educational electronics.

That flexibility of Coverdell use through a student's last year of high school earns grade 12 this week's By the Numbers honor.

Coverdell money also is available regardless of whether your student is in private or public school. In fact, you can use the funds to pay that private schoolroom tuition.

There are, however, limits.

Income limits on contributions: The $2,000 annual maximum contribution limit -- which just happens to be the this week's By the Numbers figure -- is per child, not account.

This means if a parent sets up a Coverdell for a child and grandparents set up another one for the same youngster, the total put into both accounts each year cannot exceed $2,000.

There's also a dollar limit on just who can contribution to a Coverdell ESA.

Parents, grandparents, aunts and uncles or others who have an adjusted gross income of more than $110,000 as a single taxpayers or $220,000 if married filing jointly cannot put money into a Coverdell for their favorite kid. Folks with AGIs of slightly less (between $95,000 and $110,000 for single persons and between $190,000 and $220,000 for joint filers, can contribute some, but not the full amount.

A workaround in high-income cases is giving the Coverdell beneficiary child or grandchild the cash and letting them, at their lower or no-tax level, put the money into the ESA themselves.

Keep an eye on birthdays: There also are age limits.

Coverdell contributions can be made, in most cases, only until the youngster turns 18. There is no age limit, however, for Coverdells for kids with special needs. This is defined as a person who requires additional time to complete his or her education because of a physical, mental or emotional condition, including a learning disability.

Age 30 also is important. Coverdell funds must be used for the child's qualified education expenses before he or she reaches age 30. If there is money left in the account as the child nears his or her third decade, the money can be transferred to a relative for use by that person toward education costs.

As with the contribution age limit, the distribution age restriction doesn't apply to special needs Coverdell beneficiaries.

If the Coverdell money isn't used for qualified school expenses or rolled over, the account beneficiary will face taxes on the amount at ordinary income rates, along with a 10 percent penalty.

More Coverdell coverage: You can find more on Coverdell ESAs, which became a permanent part of the tax code when the American Taxpayer Relief Act of 2012 (aka the fiscal cliff tax bill) was signed into law on Jan. 2, 2013, in chapter 7 of IRS Publication 970, Tax Benefits for Education.

The Coverdell account also is featured as the latest Weekly Tax Tip.

If you have kids or grandkids or nieces or nephews or just a neighborhood youngster you want to help meet school costs, check out the Coverdell benefits.

You also might find these items of interest: 

• School's back. So are some, but not all, education tax breaks
• Congress wants to consolidate the many education tax breaks
• Scholarships and grants get better grades
  than borrowing and tax breaks as ways to pay college costs