Tax planning and compliance for investors
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The special rules that apply here are favorable in some ways and unfavorable in other ways.
The tax law provides somewhat unusual treatment under the estate and gift tax for both Coverdell accounts and 529 plan accounts. On the whole these rules are favorable, but they have unfavorable aspects.
A contribution to a Coverdell account is treated as a completed gift of a present interest. That's taxspeak for the kind of gift that qualifies for the annual gift tax exclusion. Normally, if you make a gift in a trust and retain the kind of controls you can have in a Coverdell account, the gift will not qualify for the annual gift tax exclusion. The special rule here allows you to make annual contributions to a Coverdell account without filing a gift tax return, if your total gifts for the year are within the annual exclusion amount.
However, a contribution to a Coverdell account does not count as a tuition payment that can be excluded from gift tax treatment. That means you have to treat this contribution as a gift when you add up your total gifts for the year to this beneficiary. If the total is greater than the annual exclusion amount you'll have to file a gift tax return.
Given that you're making a gift when you put money into a Coverdell account, you would expect to find that you're not making a gift when you take money out. And that's what the law provides. Except in the case of certain changes in beneficiary described below, there's no gift at the time money is withdrawn from a Coverdell account.
When you change the beneficiary of a Coverdell account you're changing the owner. In most cases this change in ownership is not considered a gift. Yet a change in beneficiary to someone in a generation below the generation of the current beneficiary is treated as a gift by the current beneficiary. There are detailed rules for assigning family members to generations for purposes of this rule, but the basic idea is as follows:
Example: You set up a Coverdell account for your son but never used it for his education. If you change the beneficiary to one of his brothers or sisters, there is no gift for tax purposes even though there was a transfer in ownership of the property. Similarly, there's no gift if the new beneficiary is your son's aunt or uncle, because they're in a generation above your son's generation. If the new beneficiary is your son's child, or your son's niece or nephew, your son is treated as making a gift, and must file a gift tax return if total gifts to that person for the year exceed the annual exclusion amount.
When a contribution to a Coverdell account exceeds the annual exclusion amount, the donor can elect to spread the gift tax treatment over five years. This rule has no significance for regular contributions to Coverdell accounts because the $2,000 maximum is smaller than the annual gift tax exclusion. It's possible this rule will apply when a change in beneficiary results in a gift of a Coverdell account that has grown to a value greater than the annual exclusion amount, but we'll need further guidance from the IRS before we're certain the rule applies in this situation.
Normally, if you retain the kind of powers you can have in a Coverdell account for your child, the value of the trust would be included in your estate at death for purposes of the estate tax. Under a special rule, a Coverdell account is not included in the estate of the person who set it up. There's one exception: if a gift greater than the annual exclusion amount was spread over five years as described in the preceding paragraph, part of the gift will be included in the donor's taxable estate if the donor dies within five years after making the gift.
What about the beneficiary's estate? Normally this isn't an issue because you would rarely see a beneficiary of a Coverdell account with enough assets to worry about estate tax. Where that may be a concern, though, there's a special rule. The amount included in the beneficiary's estate is only the amount distributed on account of the beneficiary's death. It appears that if the account continues after the death of the beneficiary, because another individual was designated to receive the account on the death of the beneficiary, the account will not be included in the taxable estate of the deceased beneficiary.
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