Coverdell Educational Savings Account (CESA)
A CESA is a nondeductible account that features tax-free withdrawals for qualified expenses associated with a child's elementary, secondary or higher education.
There are two requirements for a CESA. First, the child for whom you are contributing may not have had any contributions on his/her part to a state prepaid tuition program in that year. Second, if you're a single filer, you may make a full contribution if your MAGI is $95,000 or less, or a partial contribution if your MAGI is between $95,000 and $110,000. If you are married filing joint, you may make a full contribution if your MAGI is $190,000 or less, and a partial contribution if your MAGI is between $190,000 and $220,000.
You may contribute up to $2,000 per year per child to a CESA. If you are ineligible to make a CESA contribution yourself, you may gift $2,000 to your child so that he or she may make a contribution. There is no stipulation as to who the contributor must be, and there is no earned income requirement. Contributions are not tax deductible.
The child has to be under the age of eighteen. You can make contributions up to the day before his/her 18th birthday.
Taxes and Penalties
Neither you nor the child pays taxes on the distributions of a CESA, provided the money is used for qualified education expenses. Qualified withdrawals may be used for tuition, fees, books, tutoring, special needs services, supplies (including computers) and room and board for elementary, secondary or higher education. Distributions must be made during the year in which the expenses occurred.
If a non-qualified distribution is taken, the earnings portion is subject to a 10% penalty and income taxes.
You can roll funds from a CESA for one child to a CESA for another child in the same family. This way, if one child decides not to pursue an education, another relative can benefit from the CESA.
You cannot roll funds from a Traditional or Roth IRA into a CESA.
Contributions to CESAs may be made until the federal tax filing date for the previous year.
A Traditional IRA defers taxes on earnings until distribution, and may allow you to take a deduction for your contributions as well.
If you are under age 70 1/2 for the entire tax year and have earned income (or taxable alimony), you can have an IRA, even if you participate in a pension plan established by an employer.
The current contribution limit is $5,500 (2018); the contribution limit for age 50 and older is $6,500(2018).
Deductibility depends on income and participation in an employer-maintained retirement plan. If you are not an active participant in an employer-maintained retirement plan, you are eligible for a full deduction, no matter what your income.
If you are an active participant in an employer-maintained retirement plan and you make contributions, the amount of your modified adjusted gross income will determine if any IRA contributions are also deductible.
If you are not eligible for a deductible IRA, you can still make non-deductible contributions to an IRA, or you may be eligible for a Roth IRA.
Distributions without IRS Penalties
Distributions after you reach 59 1/2 are without IRS penalty. There are also no penalties: if you become disabled; upon your death; if the distributions are part of certain periodic payments; for medical expenses greater than 7.5% of your adjusted gross income; or for health insurance if you've been unemployed and have been receiving unemployment payments for 12 weeks; for certain higher education expenses; or for a first-time home purchase.
In addition, when you reach age 70 1/2, you must begin taking distributions to avoid IRS penalties.
Taxes on Distributions
If you are over age 59 1/2, simply include the taxable portion of the amount withdrawn (generally the deductible contributions and all earnings) as income on your tax return. If you are under age 59 1/2 and do not meet one of the exceptions, you must also pay a 10% IRS penalty for premature distribution, in addition to including the amount withdrawn as income on your tax return.
The nondeductible portion of the distribution is not subject to either income tax or the 10% premature distribution penalty.
IRAs for the taxable year can be opened and funded at any time between January 1 and the date the tax return is due, excluding extensions.
The Roth IRA is a nondeductible account that features tax-free withdrawals for qualified distributions after a five-year holding period, and reaching age 59 1/2.
There are two eligibility requirements for a Roth IRA: you must have earned income and your Modified Adjusted Gross Income (MAGI) cannot exceed certain limits. You may contribute 100% of your earned income up to maximum allowed. The maximum is the aggregate amount that you can contribute to any Roth and/or Traditional IRA in a given year. There are no required distributions from a Roth IRA.
The current contribution limit is $5,500 (2018); the contribution limit for age 50 and older is $6,500 (2018).
Five-Year Holding Period
The five-year holding period begins with the tax year for which the first contribution is made. For example, you can open a Roth IRA on April 15, 2017 for tax year 2016, and the five-year period would actually begin January 1, 2016.
In order for earnings to be tax-free, you must first meet a five-year holding period for your Roth IRA. After that, your earnings are tax-free and IRS penalty free. Qualified distributions include:
- Distributions made on or after the date on which you attain age 59 1/2
- Distributions made to your beneficiary or estate upon your death
- Distributions attributable to your being disabled, and
- Qualified first-time home buyer distributions (up to $10,000)
IRS Premature Withdrawal Penalty
The 10% IRS penalty does not apply to earnings you withdraw under any of the qualified distributions. In addition, the penalty is waived for certain other distributions, but you will pay taxes on the earnings withdrawn on these distributions:
- Substantially equal periodic payments
- Eligible medical expenses in excess of 7.5% of your adjusted gross income (AGI)
- Medical insurance premiums for eligible unemployed individuals
- Qualified education expenses
- Distributions taken within the first five years for these reasons: age 59 1/2, death, disability or home purchase
Distributions taken for any reason other than a qualified reason or one of the reasons listed above are subject to both taxes and the 10% IRS penalty on any earnings that are withdrawn.
Access to Funds
One of the most helpful features of the Roth IRA is that, for non-qualified distributions, original contributions are returned first, not the earnings. Your contributions are not subject to taxation or the IRS 10% penalty. In plain language, you can always get back your contributions both tax-free and IRS penalty free, for any reason.
Unlike a Traditional IRA, you are never required to take distributions, at age 70 1/2 or at any other age.
IRAs for the taxable year can be opened and funded at any time between January 1 and the date the tax return is due, excluding extensions. For most people, this means that you can fund a 2016 IRA from January 1, 2017 through April 18, 2017.
Today there are many great investment options. Take a look and see which of these IRA and savings options fit your circumstances best.
- Tax-free Roth IRA (funded with after-tax money, you pay NO taxes on the earnings even at distribution)
- Fully deductible Traditional IRA (you pay taxes on contributions and earnings when you take out the money at retirement)
- Non-deductible Traditional IRA (you pay taxes on only the earnings at distribution)
- Coverdell Educational Savings Account to help a child pay for higher education expenses
Then contact our Member Contact Center, (316)722-3921, ext. 202, to open your IRA account, or with any questions that you have about your retirement planning.