More on Contributions to
Coverdell Accounts

Rules for contributions to a Coverdell education savings account.

(Continued)

529 Plan Contributions in the Same Year

At one time, a penalty would apply if there were contributions to a 529 plan and a Coverdell account for the same beneficiary in the same year. That restriction disappeared in 2002. As a result, you don't have to give up the Coverdell account if you're saving more than $2,000. For example, if you're saving $5,000, you can put $2,000 in a Coverdell account and $3,000 in a 529 plan.

Retirement Savings in the Same Year

Contributions to a Coverdell account have no effect on the amount you can contribute to an IRA, 401k plan or other retirement account.

Excess Contributions

What if you contribute too much to a Coverdell account? This can happen various ways:

• You forget you already contributed to a Coverdell account for this beneficiary, and make another contribution, perhaps to a different account, for the same person.
• You make a contribution after the beneficiary turns 18.
• You make your contribution and later find that your income for the year is higher than you expected, so the amount you're allowed to put in the Coverdell account turns out to be smaller than your actual contribution.
• Two relatives each make contributions to Coverdell accounts for the same student without consulting each other. Remember, anyone can contribute to a Coverdell account, but the $2,000 limit applies to all contributions by all people for any one beneficiary for any one year.

Unless there is a timely corrective distribution, a 6% penalty tax applies to the excess contribution. What's more, the 6% penalty applies to the same excess every year until it's withdrawn from the Coverdell account (or treated as withdrawn as explained below).

Example: In a year when you're permitted to contribute $500 to a Coverdell account you contribute $1,500, and there is no corrective distribution. There's an excess of $1,000, so a $60 penalty applies. If the $1,000 excess isn't removed by the end of the next year, another $60 penalty applies. The penalty applies over and over to the same $1,000 until the excess is corrected.

Corrective Distributions

For the year of the excess contribution, you're allowed to avoid the penalty by pulling the excess out of the Coverdell account, together with any earnings on that amount, by June 1 of the year after the year of the excess contribution. Any earnings withdrawn as part of a corrective distribution are taxable in the year of the excess contribution, even if the distribution occurs in the following year.
    It appears that this withdrawal is to be treated as a distribution to the beneficiary, and any income that must be reported should appear on the beneficiary's income tax return.

Later Corrections

If you don't take a corrective distribution as described above, you should still correct the excess as soon as possible because the 6% penalty tax applies every year until you do so. For later corrections you have to take the money out by the end of the year (you don't get until the following April 15). You don't have to withdraw the earnings in this case, however. You simply withdraw the amount of the excess. Also, you can be treated as if you made a withdrawal if you contribute less than the maximum amount to the Coverdell account in the later year.

Example: You made an excess contribution of $500 in 2002 and failed to take a corrective distribution. The 6% penalty tax applied for 2002. For 2003 you were eligible to contribute $2,000 to the Coverdell account but you contributed only $1,500. You contributed $500 less than the maximum, so you're treated as if you withdrew the $500 excess from the previous year. The excess is eliminated, so there will be no penalty for 2003.

Reporting Excess Contributions

IRS forms and publications indicate that any taxes or penalties resulting from excess contributions go on the tax return of the beneficiary, not the person who made the excess contribution. If the excess contribution wasn't corrected, the beneficiary will have to attach Form 5329 to his or her Form 1040 for the year (even if the beneficiary is an infant!) and pay the 6% penalty tax. If there was a corrective distribution with earnings, the beneficiary has to report and pay tax on those earnings.

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