Intro to ESAs
(Coverdell Education Savings Accounts)

Establishing an ESA

How do I establish an ESA?

The first thing to do is determine if you are eligible to contribute to an ESA. The beneficiary of the account must be under the age of 18 at the time of the contribution. There is no requirement that the beneficiary be your child or have any other particular relationship. Also, your income must be below a certain level in the year of your contribution. Contributors must have less than $190,000 in modified adjusted gross income ($95,000 for single filers) in order to qualify for a full $2,000 contribution. The $2,000 maximum is gradually phased out if your modified adjusted gross income falls between $190,000 and $220,000 ($95,000 and $110,000 for single filers). You can contribute to both a 529 plan and an ESA for the same beneficiary if you wish. This was not permitted prior to 2002. The next step is to decide where to establish the ESA. Any bank, mutual fund company, or other financial institution that can serve as custodian of traditional IRAs is capable of serving as custodian of an ESA. Your cash contribution can be invested in any qualifying investments available through the sponsoring institution—stocks, bonds, mutual funds, certificates of deposit, etc (but not life insurance). There is no limit to the number of ESAs that you can establish for any one child (as long as the total contributions stay within the $2,000 limit), but you will probably find that annual fees and sponsor-imposed minimums make multiple ESAs impractical in most situations. You will then need to complete the ESA enrollment forms from the sponsor, including the designation of a beneficiary and a "responsible individual", and make the contribution.

Our income is above the allowable limit. Can our child make the contribution?

Yes, there is no problem with having your child, who has income below the allowable limit, make the ESA contribution. You can simply gift the money to the child first. There is no requirement that the contributor have earned income as there is for traditional and Roth IRAs.

Do we have until April 15 of the next year to make the $2,000 contribution, like we do with our traditional IRA?

Yes, the law allows you to make your contribution after the end of the year and apply it to the prior year limit as long as it is made before the April 15 tax filing deadline.

The $2,000 annual contribution limit doesn’t seem high enough, considering how much college is going to cost by the time my child goes to college. Can we have different family members each set up an account and contribute $2,000?

The answer, unfortunately, is no. Besides the $2,000 annual limit on how much you can contribute for a particular child, there is also an overall $2,000 annual limit on contributions to ESAs for the benefit of that particular child. If multiple accounts are established, and more than $2,000 is contributed in total, the excess is subject to a 6% excise tax penalty. You can eliminate the penalty by withdrawing the excess contributions (and earnings on the excess, taxable to the beneficiary in the year the contribution was made) before May 31 of the following year. If you do not do this, the excess contribution will be subject to penalties in subsequent years unless withdrawn or "absorbed" by unused annual contribution allowances.

Can a corporation, partnership or other non-living entity make the contribution to an ESA?

Yes. The tax law does not restrict the ability to make contributions to living individuals. Corporations and other entities may make contributions without regard for the usual donor income limit.

If anyone can establish an ESA for my child, how will we know if more than the $2,000 limit has been contributed?

You will most likely be able to find this out after the end of the year when the institutions sponsoring the ESAs mail out contribution information on Form 5498 to your child shortly after April 15. If you see that more than $2,000 has been contributed for your child, you know you have a problem, but one that can be corrected with a refund by May 31.

If my child’s grandparent contributes $2,000 to my child’s ESA but should not have contributed anything because the grandparent’s income was too high, who pays the excise tax?

Since the Form 5329 is filed with your child’s tax return, it looks like your child is ultimately responsible for the penalty. How would you or your child know whether the grandparent is eligible to contribute $2,000? That is a mystery to us, too.


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