- Opening a Coverdell ESA allows you to set aside funds for the school expenses of the beneficiary you designate. As of 2011, you may contribute up to $2,000 to the account per year until the beneficiary reaches the age of 18. However, exceptions to this age restriction exist for beneficiaries who have special educational needs, such as if those beneficiaries who have a disability. Although your contributions to the account aren't deductible, the funds within the account may earn interest income tax-free for the life of the account. In contrast, setting aside the funds in an ordinary savings account requires that you report the annual interest earnings on your tax return.
- In addition to tax-free growth for your contributions if you're the account owner, the student-beneficiary doesn't incur an income tax liability when he withdraws the funds to pay for school expenses. However, the beneficiary pays tax on the portion of the distribution that relates to the accumulated interest earnings if he uses the funds to pay for expenses that exceed adjusted qualified expenses. Essentially, the federal government wants to insure that the student uses the tax-free income for the purpose it was intended for.
- For purposes of determining whether a portion of a Coverdell distribution is taxable, calculate your adjusted qualified education expenses as total qualified education expenses minus all other tax-free assistance you receive to attend school, such as Pell grants and private scholarships. Qualified education expenses only include the tuition, fees, books, supplies and equipment that the post-secondary school requires direct payment for as a condition of enrollment. It also covers the cost of room and board, but only for students who enroll at least half-time during the academic year. If the student uses the funds to attend an elementary or secondary school, the additional qualified expenses include the cost of uniforms, transportation and academic tutoring. However, the student must enroll in an eligible educational institution first.
- For a student who enrolls in a post-secondary institution, such as a college, university or vocational school, the IRS requires that the school be eligible to participate in the U.S. Department of Education's student financial aid program. However, if you intend on using the funds for an elementary or secondary institution, the IRS defers to recognition it receives by the state government in which the school is located. For example, the tuition that a Catholic elementary school charges is a qualified expense if it satisfies all state requirements to operate.
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