Contributions to Coverdell Accounts

The basic rules for contributions to Coverdell accounts are pretty simple. The details of these rules are — well, let’s just say Congress wasn’t thinking carefully when they wrote these rules. Fortunately, most people won’t have to deal with the strange twists we’ll note below.

Who Can Contribute

Subject to the income limitation described below, anyone can contribute to a Coverdell account for a particular child. Parents, grandparents, aunts and uncles — even a friend of the family can set one up. The child can even contribute to his or her own Coverdell account. And that’s not all: corporations and trusts can contribute. You don’t need to have earned income (or any income at all) to contribute to a Coverdell account. As discussed below, you can’t contribute if your income is too high, but most people can get around that rule if they really want to set up a Coverdell account.

Timing of Contributions

Contributions must be made before the beneficiary turns 18. You’re allowed to make a contribution during the same year the beneficiary turns 18, but you should make sure it goes into the account before the beneficiary’s 18th birthday.

Although you can’t contribute to an account after the beneficiary turns 18, you can change an account from one beneficiary to another who is over 18 but not yet 30.

You can contribute for a particular year any time from the beginning of that year until the April 15 of the following year (or to be technically precise, the beneficiary’s return due date, without extensions). If you contribute between January 1 and April 15, be sure to specify the year for which you’re contributing.

Cold Hard Cash

All contributions must be in cash. If you want to use something else, like stock, you have to sell it (reporting gain or loss) and contribute the sale proceeds.

No Deduction

You don’t get a deduction when you contribute to a Coverdell account. It’s important to keep track of the amounts you contribute, though. As we’ll see later, if there is ever a taxable distribution, the portion of the distribution that’s considered a return of contributions is not taxable.

Per Child Contribution Limit

The annual contribution limit is $2,000 per child. If you have three eligible children you can contribute $2,000 for each of them. But you can’t contribute more than $2,000 for any one child even if you set up multiple Coverdell accounts for that child. What’s more, if someone else has contributed to a Coverdell account for the same child, the amount you can contribute is reduced. The $2,000 limit applies to all contributions from all contributors to allCoverdell accounts for any one child for a given year.

Example: Your sister-in-law put $1,200 into a Coverdell account for your daughter earlier this year. If you also want to contribute to a Coverdell account for your daughter (the same account or a different one), the amount you can contribute is limited to $800.

If you’re contributing to a Coverdell account and believe there’s a possibility anyone else might set one up for the same child without telling you, it’s a good idea to get the word out. Excess contributions lead to burdensome paperwork and, if not promptly corrected, a tax penalty for the beneficiary.

This is the first place we run into something strange in these rules. The way the law reads, ten different people could set up Coverdell accounts for the same person without telling anyone else. Each of them could contribute $2,000, and all but one of them would be making excess contributions, potentially resulting in a penalty.

The IRS tried to address this problem in the forms used to set up Coverdell accounts. These forms say the person who is setting up the account (called the grantor or the depositor) has to name a responsible individual to be in charge of the account, and this person has to be a parent or guardian of the beneficiary (the child). Technically, you aren’t required to use the IRS forms to set up a Coverdell account, but most banks or other trustees will require you to do so. That should take care of the problem, unless different parents or guardians for the same person become responsible individuals for different Coverdell accounts without telling each other.

Income Limitation

If your income is higher than the level specified in the tax law, the amount you can contribute to a Coverdell account is reduced or eliminated. The income that counts for this purpose is your modified adjusted gross income (or modified AGI). Adjusted gross income is the amount left after claiming certain types of deductions (such as business deductions and contributions to a traditional IRA) but before you take exemptions or itemized deductions. On a regular Form 1040, it’s the number at the bottom of the first page of the return.

To arrive at modified AGI, you have to increase your adjusted gross income by certain amounts that may have been excluded from your taxable income. These items relate to earnings outside the United States, so for most people modified AGI is the same as adjusted gross income.

For married taxpayers filing jointly, the $2,000 contribution limit begins to be phased out when modified AGI exceeds $190,000, and is completely phased out when modified AGI reaches $220,000. For all other taxpayers the $2,000 contribution limit begins to be phased out when modified AGI exceeds $95,000, and is completely phased out when modified AGI reaches $110,000.

Example: Suppose the modified AGI on your joint return was $197,500. That’s one-fourth of the way from $190,000 to $220,000, so one-fourth of the $2,000 limit is eliminated. You can contribute only $1,500.

Avoiding the Income Limitation

The income limitation for Coverdell account contributions are so generous that few people have to worry about it, but if you’re one of those people, there are ways to get around it.

One way is to have the child make the contribution. Nothing in the law prohibits this, and the IRS explicitly says, in Publication 970, that this is possible. To do this, you must first make sure you’ve made a completed gift to the child, which may be a transfer to a custodian under the Uniform Transfers to Minors Act. It appears you could name yourself as trustee or custodian, but you must go through the necessary paperwork of getting the money into a custodianship before moving the money into a Coverdell account. Once the money is in a custodianship, the contribution is coming from the child, and the income limits don’t matter unless the child has over $95,000 of income. You would fill out the Coverdell account forms as custodian for your child’s assets.

If you take this approach, you should set up the Coverdell account to prohibit a change in beneficiary. You want to make it clear that this contribution was from money owned by the child, so it isn’t appropriate to retain the right to change the beneficiary to a different child.

As noted earlier, trusts and corporations are also allowed to contribute to Coverdell accounts. There is no income limitation for contributions by trusts or corporations, so if you happen to have a trust or corporation you can use for the contribution, you can avoid the income limitation that way also. The problem here is that the Treasury has not seen fit to explain the tax consequences of such contributions, other than to say they are allowed under the rules for Coverdell accounts. Presumably, if you own a corporation and cause it to contribute to a Coverdell account for your child, the contribution is some form of income to you — wages or a dividend — but the present rules leave this to our imagination.