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Ralphs. Fresh for everyone. ♪ Hey, Radicals. This is Joshua Sheets. Real quick, before we begin, I just finished recording today's show. It's an epic. It's two and a half hours long, as you'll hear in just a moment. And it's about the topic of the Coverdell Educational Savings Account. But I felt I needed to come back here and just give you a bit of a reason to listen.

Would you like to pay for your kids' homeschool expenses with tax-free money, tax-free growth? Would you like to pay for your 16-year-old's iPad with tax-free money? Would you like to provide for your disabled child without dealing with some of the restrictions of setting up a trust? Would you like to be in a situation where you can invest in real estate for the purpose of your child's education, and pay for that, and get all tax-free money coming off of that real estate when paying for your child's education?

Would you like to pay and invest for your child's education by buying and selling options, or trading in precious metals, maybe gold coins, or that type of thing? That's what today's show is about. And I want you to really give this a shot, because many of you are going to find some ways to save a lot of money in today's show.

There are some really great planning deals in this situation. And all of this stuff, when I say education, it applies to elementary school, it applies to high school, it applies to all of this. There's one of you in the audience, at least, who's a real estate investor who can use the information in today's show to set up a deal that's going to pay for your child's private school tuition in elementary school, high school, and college, all with the information in today's show.

I'm sure it's possible. So this show is big, though, and it's deep, and it's hardcore. We get into some real nitty-gritty with financial planning. But I want you to give it a shot. And I really worked hard on it, and I hope you like it. It's long, and it's involved.

Split it up, if you need to, and take it into different episodes. Spread it out so that it's not too much for you. But there are a lot of planning ideas in here, and I've never found someone else who's put this together for you, especially not in an audio format.

So I hope you'll give it a listen. If you're intimidated by it, I'm going to talk a lot about some detailed financial planning stuff. We talk about bankruptcy protection. We talk about college tuition protection and financial aid benefits. We talk about taxes and all of this stuff in today's show.

Give it a shot, even if you are not a financial planner, and even if you're kind of a neophyte to the world of financial planning, because you need to be exposed to some of this more in-depth stuff. And even if you don't understand everything that I cover in today's show, please give it a shot, because over time you'll start to understand more.

So when we're talking about annual gift tax exclusion amounts, you may not know what that means today, but you can look it up, and then you'll start to see as we go forward. And I want to take you beyond the elementary concepts. If it's too hardcore for you today, if the depth is too great, skip to one of my fluffy shows.

But don't skip it forever. Dig into shows like this, and you'll start to see where the really good stuff is. I think you'll really benefit from it. I think you'll really find some deals in here, and some of you guys are going to use some of the concepts in this show to save yourselves a couple hundred thousand bucks.

Let me know what you think. I hope that it is a little—it's a lot. I warn you that up front, but I think it's worth it, and I think I gave you really good content in the best format I was able to. And again, I've never found anybody bring this information together on this subject, especially if you're interested in college planning or high school planning or elementary school planning, this is going to be useful for you.

So with that intro, here's the show. Today on the show, I'm going to bring you a legitimate epic on a topic that you've probably not thought that much about. And even if you've read some or thought about this subject some, you probably aren't going to believe some of the information that I bring you, because I'm probably going to destroy just about every article you've ever read on this topic.

And it's on the wonderful, amazing, exciting topic of the Coverdell Educational Savings Account. Welcome to the Radical Personal Finance Podcast. My name is Joshua Sheets, and I'm your host. Thank you for being with me. Today is Thursday, November 20, 2014. And today's show is indeed going to be an epic.

Not only epic, but it's going to be an epic. But it's an epic that's going to save you possibly tens of thousands, for some of you, hundreds of thousands of dollars of taxes. We're going to be talking about the Coverdell Educational Savings Account, and we're going to be talking about it in detail.

And I want to sell you on the idea of listening to this show first. This show is not going to be short. It's not going to be easy. But it does legitimately have the potential to save you tens of thousands, for many of you, hundreds of tens of thousands of dollars, for many of you.

For some of you, it may be hundreds of thousands of dollars of taxes. And you won't know whether or not it's going to be appropriate in your situation unless you listen to the show. I've laid out for myself a task today that I think I can do, but it's probably going to be unlike any other financial resource that you've ever come across.

Because I'm going to try to cover in depth the topic of this account and explain to you how it works with a level that many people, that few people ever bring together. But hear me out. Give me a shot, whether you're brand new to the topic of finance or personal finance, if you've stumbled into this show just simply because somebody told you, "Hey, you know you should do an ESA, a Coverdell Educational Savings Account, and you're not familiar with the terms of financial planning," give this show a listen.

And if you are an expert, perhaps you're a financial planner, perhaps you've been dealing with these for years, give this show a listen. And I think I've got a few ideas that at least will be helpful to you. I'm going to try to do this in one show. And this is the type of thing that many people have advised me not to do.

They've advised me to take things, a show like today, and break it up into six or seven or eight different audio files. But frankly, that would annoy me to try to listen to. And I don't think it's the best thing for you, the listener. Some of today's show is going to go over your head.

If you're new to this, or even if you're intermediately knowledgeable in this area, it may go over your head. But it's still important for you to be aware of some of the information that I'm going to share with you, even if it goes over your head. And you can come back and listen to this again.

I also think it's important to deliver content like the way I'm doing it today so that you can develop a larger picture of the subject. Because you don't ever find, at least I have a very difficult time finding content like this where it's cohesive. It's all brought together and it's comprehensive.

I'm going to kick off with just an article, reading to you just an article that I think is an example of what we usually find in today's media world. It comes from Forbes magazine, from the website for Forbes magazine, published on February 28, 2013. The title is called "Paying for College Coverdell Accounts." First line, written by the eminent William Baldwin, evidently, who writes about investing and taxes.

His first line, "These are stupid. A Coverdell, aka an education savings account, allows you to accumulate investment earnings tax-free. As with a 529 account, you get no federal tax deduction for contributions to a Coverdell. As with a 529, a withdrawal is tax-free if it is used on education." And he goes into four short differences and he concludes with, "In short, there's differences between the Coverdell and the 529." And let me read them to you.

This is only a half a page. He says, "First, a Coverdell contributions are limited to $2,000 a year. 529s are pretty close to unlimited. If you bump into a limit on the 529, it's on the account balance and it's likely to be between $250,000 and $400,000. Second, the right to contribute to a Coverdell is phased out as the parent's income passes $190,000.

The 529 has no income rules. Third, there's a good chance you'll get a state tax deduction on a 529 contribution. You won't get one on a Coverdell. Fourth, Coverdells have time limits. They have to be started before the beneficiary turns 18 and used up by age 30. In short, there's nothing a Coverdell can do for college costs that a 529 can't do better.

Coverdells can also be used for K-12 private schools, but even there seem rather pointless. Your accumulation time is necessarily shorter and the $2,000 a year you're putting in is maybe a tenth of a year's tuition bill. Invest in a Coverdell if your main objective in life is to enrich your accountant.

This is common to what you see. You either see articles like this in the financial press or you see comparisons of six bullet points between a 529 account and a Coverdell account. If you read those things, you go away scratching your head more confused than ever. Over the course of today's show, I will destroy three of his points and show that this man doesn't know what he's talking about, has obviously never read the rules, and then I will give a caveat.

The only point of his that is valid is the third point, which is there's a good chance you'll get a state tax deduction on a 529 contribution, but you won't get one on a Coverdell. That's the only one of these four points that I think is valid. I'll just destroy the other three for you.

Here's a guy. He's a very knowledgeable guy for all I know. It looks like he's an enrolled agent, a practicing accountant, an investment commentator, writing for one of the most well-respected Forbes magazines, very well-respected as far as a professional publication. I've just said I'm going to destroy all of the points of his article.

It's funny. I didn't mean to do this. I was doing my preparation in today's show, but I actually ran into this guy in an argument I was having the other day in a forum that I subscribe to, a private forum. I'm arguing with the guy who hosts the forum.

He cites this guy's work, and it's about long-term care insurance. I came back, and I had to destroy his argument there. It's not him. I don't have anything against him. I don't know anything about him. I had to destroy his argument about why nobody should ever buy long-term care insurance and everybody should buy deferred fixed annuities instead, which is certainly a valid consideration, but it's not a valid consideration for the topic because he clearly doesn't understand the financial planning problem.

If you understand the financial planning problem that you're trying to solve, then you just look at all of these things as a tool. So you can come back, and after you listen to today's show—maybe I'll finish up with this after the end of this lengthy episode—you come back and you consider his arguments, and I'll show you how to debunk each and one of his arguments.

I'm not mad at him or even the popular press. I understand why the popular press does what they do, but it really bogged me down, and this is the thing you've got to be aware of. You cannot say that a Coverdell is better than a 529 or that a 529 is better than a Coverdell.

It may be better for you in your circumstances, but that is not the same thing as it being better because in other circumstances, the opposite is going to be better. That is how financial planning is and how it works. So bear with me in today's show and give it a shot.

Don't be intimidated by the length stretch this out into multiple episodes or multiple listening experiences, but I believe that if I do this in one audio file, it's going to be far more useful to you and far more helpful to understand. So give me a shot. Real quick as we get started on today's show, sorry this wasn't out yesterday.

I'm a day late on this. I had this planned out and then sat down to record and knew that I couldn't finish. I had a busy day yesterday with several meetings. I didn't have the time to record it and I didn't want to do it an injustice of giving it a rushed treatment.

So I apologize for that to those of you who tune in each day as I release them. I also want to just make a quick comment. I'm going to go into a lot of detailed information on this topic and I'm going to be touching on things that are very specialized areas of financial planning.

So for example, I'm going to be talking about the basics and introductory, but I'm also going to be talking about some detailed investment topics. I'm going to be talking about some detailed bankruptcy law. I'm going to be talking about some detailed estate tax scenarios and I'm going to be talking about some details on financial aid calculations and how an educational savings account matters from the perspective of financial aid calculations.

All four of those disciplines that I just mentioned are very specialized and rightly so, very specialized areas of financial planning. I am not an expert in each of those areas. If you find something that is a mistake in today's show, please let me know. I believe I'm accurate with everything.

I've carefully researched this and prepared for this. But many of you who are experts might catch me saying something that's wrong. Please let me know. All of the show notes for today's show can be found at RadicalPersonalFinance.com/Coverdell, C-O-V-E-R-D-L-L, or if you can't spell it, you can also find them at RadicalPersonalFinance.com/106, 1-0-6 or slash Coverdell.

Please comment there and correct something. If you're going to take action on the information that I'm presenting in today's show, the first thing you should do is go to that website and look to see if anything that I mentioned in today's show was corrected in the comments by somebody who is more of an expert on this area than I am.

All right. Preamble done. Let's get into the content. So I'm going to start with just a big picture overview of what is a Coverdell educational savings account and how does it work. Essentially, this is an account which the tax law has authorized that permits you to save for college.

And if the investments grow, you can avoid the tax on the growth of your investments as long as those investments are used for college. From a taxation perspective, this account works similar to the way that a Roth IRA works. If you're familiar with the way a Roth IRA is taxed, where you earn a dollar of income, you go ahead and you pay your income taxes on that money, and then you invest what's left over after you pay the income taxes.

Then that investment grows, and then as long as you take the money in a Roth IRA out and spend it on the allowable expenses, retirement in the case of a Roth IRA, then the money comes out with no tax on the investment growth. So there is no upfront tax deduction, but the investment grows and comes out tax-free.

So from a tax perspective, this is the same as a Roth IRA. It's also the same as a Roth IRA. Let's just leave it at that. Keep it simple. This, for me, for years was actually a major misconception that I had even when I was a new financial advisor.

For some reason, I had in my head that a Coverdell educational savings account was tax deductible upfront and then on distribution was tax-free also, which would be a double benefit. That is not the case. The only thing for which I'm aware of that's the case is actually long-term care insurance, but we'll leave that one for a different day.

So a Coverdell, there's no upfront deduction, but the benefit can come out tax-free. So from that perspective, for federal income taxes, the Coverdell educational savings account and the 529 account are taxed the same. There's no benefit from one versus the other. That's important to you. Now, oftentimes, many of you will have never heard of the educational savings account, and there are many reasons for that.

Probably the number one reason is the low contribution amounts that are permitted. You are not permitted to put more than $2,000 into this account in any given year. So that's a relatively low number, and especially in a world where the majority of us receive financial advice through the services of a financial advisor, it's tough, and especially if that financial advisor is compensated on commissions, it's tough to get a financial advisor to be willing to take the time to sit with you and talk about an account that you can contribute $2,000 per year to.

This is just the truth as I see it. When I was a practicing financial advisor, unless you had other accounts with me or unless there was some way that I was being compensated purely for my time through the form of an hourly fee, or again, unless you're a big client, I can't afford to sit down and spend time talking with you about an account that you can put $2,000 per year into, because it's not possible for me to make enough money for that to be worth my while.

I don't personally see that as a problem. I just see it as important to mention it so that you can do this for yourself, because you have to do this area of planning yourself. You can enlist the services of an advisor for the implementation of it if you want to, but you have to be aware of this yourself and see if it's going to fit your needs.

That's why I'm creating this audio resource for you. Incidentally, this is another problem also even with 529 accounts. In the years that I was a financial advisor, not a single time did I ever open a Coverdell account for a client, and it was only a few times that I ever opened a 529 account.

I wouldn't accept 529 account clients unless they were also a client for something else, simply because there's not enough assets for it to be worth my time, and you as a client are better off just going online. So I would try to give you an online resource and say, "Here, go and search this out." Now, that makes a lot of people upset, but you need to be aware of that.

That's the facts as I see them, simply due to the incentives. The way that you can get around this is if you're willing to pay your advisor a high hourly fee, or if you're willing to pay your advisor with other accounts where he or she has enough other assets under management where it's worth his or her while to service these accounts for you.

So be aware of that. I don't think it makes your advisor a bad person. You just need to be aware of that from the perspective of the incentive for the advisor. The other aspect to this discussion, even with regard to compensation of the advisor, which is one thing, but the other reason, well, the reason I never did one of these accounts was not only that there was not a lot of financial incentive, because if that were the only reason, I would personally have a moral problem with that myself from an ethical perspective of how I worked with clients, because I would have to encourage them to do this.

But the other problem is that very few people, in my opinion, in the mainstream of the United States should be using this type of account to save for their kids' college expenses. Most people are behind for other financial goals, especially retirement savings, and most people are not fully taking advantage of their other retirement savings accounts.

And you should start there, because when it comes to saving for your child's college, there are many, many other options that if you don't do that, that your child can do. For one, why would he or she go to an expensive college? There are so many cheap ways to get a college degree today that you've got to consider those as being primary.

If I were doing it over again, it's hard for me to say, because I really benefited from my college experience at an expensive private university, but at least today, being a different person than I was at 18, which how would you even know who you were at 18? But today, I would make a different decision.

I would not spend the $20,000 per year. Now, I'm glad I did it when I was 18, because I think it probably was one factor in saving my soul from going into the world and sin, but today, I would have to really reconsider that. So, you always have to question the expense, first and foremost.

Is this even worth making as an expense? So, most parents, no. The answer is no, you shouldn't be saving for your kid's college. You should be saving for your retirement. And then, if nothing else, your best plan is simply, in the years that your children are in college, stop saving for retirement and just pay that money towards their college expenses.

That's what most families will wind up doing. The other problem with these accounts is that, okay, once we've settled retirement, they're really tough to use to actually make an impact on the expenses, because the contribution amounts are so low. So, you have to keep this in mind when you are approaching the subject to say, "All right, if I'm going to save $2,000 a year into a Coverdell Educational Savings Account, and I'm going to do this for 10 years, and I'm going to earn, let's say, 8% interest on my money, starting with nothing, how much money do I have?

I have $31,290 in the account." What that means, however, what benefits me from using the account is that I save the difference between that $32,000 and the $20,000 that I contributed that would be interest income that I don't have to pay the tax on if I use it for a qualified educational savings expense.

So then, basically, what I'm saying is I'm saving the tax on $12,000 of income. Well, what's the tax on $12,000 of income? Depends on the rate, but if we say a 20% rate, that's $2,400 of tax. It's not that big of a savings for most people, and many people don't invest the money effectively enough to where it's really going to be a major benefit at all.

So you need to keep that in mind all the time when you're looking at this account and say, "Is there a way that I can actually use this account to benefit myself to a degree where it's going to be worth it?" Keep that in mind. It's really, really important.

The problem with college savings accounts is you face the factor of low contribution amounts with an educational savings account. You have a high contribution amount with a 529 account, which we'll deal with another time. You have a low contribution amount that's a permitted, so that means your total maximum savings are probably pretty small.

You have a relatively short time horizon. You can use the Coverdell account to pay for elementary school or high school, private high school or college, but most people are not, when their child is one day old, setting aside for a college tuition 18 years from now. That's not how most people function.

If that's you, this show is going to save you a lot of money, but most people aren't. Because you can't front load this account in the same way that you can with a 529 plan, you can't just toss in 50,000 bucks up front. You're even more limited by the Coverdell and by the actual potential savings from a tax perspective.

Then even worse is because you have a short time horizon, relatively speaking, you have to figure out how to fund this with investment accounts that are going to solve your needs, that are going to provide for you the income that you need to cover the expense. If you are concerned with volatility and you don't have a plan to control the volatility, then you're going to be in a situation where you have to get a lower return because you're investing for safety instead of for growth, and then your potential savings on tax are even smaller.

Because the rate of return, if you're investing, and let's say you're buying CDs over 10 years, starting with nothing, and you're getting a 3% interest rate, keeping pace with inflation, then what you wind up with in that scenario is you wind up with a future value of $23,615 after 10 years of savings.

It can grow a little bit beyond that, but now you've got $3,000. All you're avoiding is the tax on $3,615 of income, which at, say, a 20% rate would be $723 of tax. You've got to keep that in mind when you're thinking about the Coverdell Educational Savings Account, and you've got to figure out a way to solve those problems.

Because if you can't solve those problems, then this account is useless, and then Mr. Baldwin is right with his assessment, and you're better off with another account. But there are potentially some huge advantages for the Educational Savings Account. One of the biggest ones is that this can be used before college.

We can use this to fund the elementary school, private elementary school, middle school, high school. There's a great degree of flexibility with regards to what we can pay for. And then there's a tremendous flexibility with what we can invest in. So at the end of the show, I'm going to show you how to use this account to invest in real estate and pay to invest in alternative investments.

This account can do that. The 529 plan, more properly called a qualified tuition plan, cannot do that. So you need to keep that in mind. But within that context, we can understand how this account works and how we can use it. It's really important. Now, what I'd like to start with is I want to give you a little bit of the history of the Educational Savings Account.

And I like to do this because I always struggle when it comes to figuring out. People often ask me questions. "Joshua, could the rules change?" So for example, "Could the rules for IRAs change? Could the rules for Roth IRAs change?" The answer to that is yes. A lot of people are concerned about, "Well, could the government change the rules?

Could they take my money? Could they nationalize the accounts?" All of that is certainly possible. That's a risk that you face. And if you're going to subject your money to that risk, you need to be certain that the payoff and the reward is worth it. And that will change for different ones of you.

The answer of whether that actually does work or doesn't work, that will be different for each one of you. So you've got to consider this in your situation. But let me give you the legislative history of where did this account come from, how was it started, and where did it actually come from.

What we currently know as the Coverdell Educational Savings Account did not start by being known as that. This account came into being with the Taxpayer Relief Act of 1997. Pay attention to the names of this legislation when I give it to you because you'll find it funny when you pay attention to it and you start studying financial history.

So the Taxpayer Relief Act of 1997 came out with something called the Educational IRA. And the idea was that you could contribute to this account and it would be used for the purposes of higher education. Originally, the contribution amount was limited to $500 per year, and it was exclusively available for higher education, for college education.

So it was a very limited account when it first came out and it was called the Educational IRA. That was where it came from. Now, there were some major updates that happened with the Economic Growth and Tax Relief Reconciliation Act of 2001. So we started with the Taxpayer Relief Act of 1997.

Then we moved on to the Economic Growth and Tax Relief Reconciliation Act of 2001, which made these changes. As an aside, notice that all of these are designed to stimulate the economy. And notice that regardless of the political mumbo jumbo, the political parties spout, the Democrats and Republicans, which are the same party practically, but you get this idea that, "Oh, cutting taxes is bad.

We have to stop that." But when times are tough, everyone seems to agree and pass these bills. 1997, that passed under Bill Clinton. Then there was 2001 under George Bush. Then 2010 under Barack Obama. Then 2012, those are the four pieces of legislation that have affected this account under Democrat presidents and Republican presidents and Democrat houses of Congress and Republicans.

So just notice that. So moving on. So what did the Economic Growth and Tax Relief Reconciliation Act of 2001 say about this account? This one brought the biggest changes that have persisted till now. So in that law, the annual contribution on limits was increased from $500 to $2,000. So that was a big increase.

The accounts were renamed instead of being the Education IRA, because IRA is Individual Retirement Arrangement, what the IRS calls it, and we call it Individual Retirement Account. But instead of being named an IRA, it has nothing to do with retirement, so they renamed that, although the moniker still stands for some people.

And they renamed them to be called the Coverdell Education Accounts, the Coverdell Education Savings Account, in honor of, I think it was Senator Coverdell from Georgia. He died, I think he had a heart attack in Congress or in Senate, something like that. This law also expanded the definition of what the qualified education expenses were, and it included in that elementary and secondary school expenses.

Additionally, it raised the dollar restrictions for how much money you could make before you could do it. So previously it was low for married taxpayers. It raised the phase-out, what it's called, of when you can't participate, to be $190,000 to $220,000 for taxpayers married filing jointly. It also changed, it also removed the age limitations in case of special needs beneficiaries.

And so this account became applicable and was able to be used for special needs beneficiaries without any restrictions on the age. It also clarified the fact that corporations and other entities, including tax-exempt organizations, were now permitted to make contributions to these accounts regardless of the income of the corporation or entity during the year of the contribution.

That's going to be very important. It also permitted the beneficiary to claim a hope credit or lifetime learning credit for a taxable year, and then to exclude from their gross income the amounts that were distributed from the education IRA for that same student, as long as the distribution wasn't double-counted and used.

But it was claimed, the education expense was claimed both as a credit and also as a distribution from the Coverdell account. Additionally, it repealed the excise tax that formerly existed on contributions that would be made by any person to a Coverdell account on behalf of the beneficiary during any taxable year in which any contributions are made by anyone to a qualified state tuition program.

Originally, you couldn't contribute to both a qualified state tuition program and the Coverdell account on behalf of the same beneficiary. Additionally, it allowed a rollover of the unused funds to other family members as long as they are under the age of 30 without any penalties. That became effective for all taxable years after December 31, 2001.

That continued. The next piece of legislation, the $2,000 number, was only due to be in force for a certain amount of time. And it would have gone into what they call "sunset." You'll hear this word "sunset" when you talk about tax legislation, which means that this is a temporary provision under which we're going to allow these contributions.

Well, the law was scheduled to sunset, but the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 extended that $2,000 contribution amount for one year. So it extended that up till the date of December 31, 2012. Now, this is recent history. And if you remember back, this is all the blustering between the different parties and the Houses of Congress in 2012 and 2013.

This was a majorly difficult time to be involved as a financial planner because the tax law was so uncertain. And you had all these things going on with the estate tax law, with this as just one minor component of all of these tax laws that were changing, the Bush tax cuts, all this kind of stuff.

So that act in 2010 extended the $2,000 number for an additional year. And then Congress passed and the President signed the American Tax Relief Act of 2012. They actually passed it on January 1, 2013. So take that and figure that one out. And that permanently extended the $2,000 number into the future.

So the way the law sits right now, that $2,000 contribution amount has permanently existed, and to the best of my knowledge, is not indexed for inflation like some of the other ones are. It's just going to be a level $2,000 going forward. Of course, it's likely that in the future, Congress could adjust that number for inflation if they wanted to fit their purposes.

So that's the history of the law. And that brings us to where we are today. So if some of those things didn't make sense to you in the beginning there, then we're going to go through those in detail today. Anytime you're looking for tax planning info, I would encourage you to start with the IRS publications.

And the IRS publication that you want to check on today is IRS publication 970. And 970 is the publication that deals with how to pay for college and all the different aspects that are available. Chapter 7 of the publication deals with the Coverdell Educational Savings Account. And for the first part of this show, I'm going to be using that as my general outline, but I'm going to be expanding the information that's in it with some additional planning ideas for you.

So the first thing I want to talk about is who can contribute. Well, the first limitation that you'll see is, as far as who can actually contribute, is that the person who's contributing, their modified adjusted gross income, and I'll explain what that number is in a little bit, just here, modified adjusted gross income has to be less than $110,000 per year if they are a single individual taxpayer.

If they're filing a joint return, it has to be less than $220,000. And so as long as you have under those coverage amounts, then you can establish the Coverdell Educational Savings Account in order to pay for the qualified education expenses of the designated beneficiary. Now, right here on the front, you're going to see how in some ways the tax law makes sense, in other ways, it makes absolutely no sense.

And the first thing is, that is the most easily circumvented rule, period. And I'm going to, because I can, you make $5 million a year, I can easily have you contribute and set up one of these accounts. Now, it's probably not going to be at all meaningful in your tax planning, but I'll show you how to do that.

And basically the rule is you either give the money to the kid, stick the money in a trust and have the trust make the contribution or use one of your companies to make the contribution. And in all three of those, there's no income allowances. So if you're a financial planner, for the CFP exam, you need to be aware of $110,000 for an individual, $220,000 for a joint couple.

If you're actually doing financial planning for a family though, that is the most utterly pointless number because it's so easily circumvented, it's ridiculous. This is what happens when politicians write laws, or excuse me, sign laws that they don't have a clue what's in them and they don't go together.

It's frustrating. The next big thing that you need to be aware of is that the benefit can be used not only for college expenses, but also for elementary and secondary expenses. And that's a big, big benefit. When the money goes in, the money is not tax deductible, but it grows tax free until it comes out.

That includes also, I think, you need to check your state. I've checked this with as many states as possible, but that also allows you to avoid your state income tax on the distributions as well. The state laws are a little funky because there's some laws with 529 accounts and things like that.

So you need to check your individual state. But it should be that in all the states, at least that I was able to find in preparation, checking my facts in preparation for the show, I do not believe you will ever have to pay state income tax on the distributions.

So check that out. Who can actually have a Coverdell account? Well, anyone can have an account as long as they're under the age of 18, or if they're a special needs beneficiary. So in order to have this, in order to be able to contribute to it and have it, you have to have the money.

And in any beneficiary, it has to be put in as long as they're under the age of 18. The money has to be put out of the account by the age of 30, but that's also easily circumvented. And I'll show you how to do that. To be treated as a Coverdell educational savings account, the account must be designated as a Coverdell educational savings account when it is created.

And there has to be a document that creates this account. It must be in writing, and it has to satisfy these requirements for the IRS to approve it. This is what defines it as being a Coverdell account, which when we get to some of the interesting planning opportunities, then you're going to hear about, then you'll see how we can use this as long as we establish, we fit these rules, we can use this in all kinds of interesting ways.

Number one, the trustee or the custodian for the account must be a bank or an entity approved by the IRS. Number two, the document must provide that the trustee or custodian can only accept a contribution that meets all of these following conditions. The contribution must be in cash. The contribution must be made before the beneficiary reaches the age of 18, unless the beneficiary is a special needs beneficiary.

And the contribution must not result in total contributions for the year, not including rollover contributions, of more than $2,000. Those are, that's what the document must state. We'll come back to those contributions and revisit those in just a moment. The money in the account cannot be invested in life insurance contracts.

So you cannot use a life insurance contract in this account. Next, money in the account cannot be combined with other property, except in a common trust fund or common investment fund. So you can't commingle the assets unless they're being commingled in a common trust fund or common investment fund.

That's going to be important when we get to some of the ways to use this, with the example being, how do I buy rental houses in my IRA and also make sure that I use that same money that's in my educational savings account? The rules do permit this, at least in my opinion.

And then number five, the balance in the account generally must be distributed within 30 days after the earlier of these two events. Either the beneficiary reaches age 30, unless the beneficiary is a special needs beneficiary, or in case of the beneficiary's death. So it must say that in the establishment documents in order for this account to qualify.

As long as all five of those conditions are established in the document, then you can indeed establish a Coverdell educational savings account. Now, next area, what is a qualified education expense? So you put your money into this account and the money grows and now you're going to take it out.

Well, if you take it out and you spend it on a qualified educational expense, then you will be able to use those proceeds and use that growth without paying any income taxes, federal income or state income taxes, on the growth in the money. This will allow you to avoid this.

So, qualified educational expenses. Generally, these are expenses which are required for the enrollment or attendance of the designated beneficiary at an eligible education institution. For purposes of Coverdell educational savings accounts, the expenses can be either qualified higher education expenses or qualified elementary and secondary education expenses. The designated beneficiary is the individual who is named in the document creating the trust or custodial account to receive the benefit of the funds in the accounts.

And one guaranteed qualified education expense is a contribution to a qualified tuition program. One of the things that when you're dealing with tax deferred accounts, you always need to keep in mind is, what's my exit plan? So I did the show last Monday on how do I get money out of a retirement account early without paying the penalty.

If you're interested, go back and find that show. It was pretty in-depth. I talked about the four different ways to get the money out without paying the penalty. One of the ways you need to be thinking about is, if I set up an educational savings account and I don't use the money, what do I do with it?

And one of the key easiest exit plans that you can possibly use is that you can just simply transfer the money into a qualified tuition program, which you would probably know as a 529 plan. Now with the educational savings account, the funds are forced out by the age of 30 for the beneficiary.

You can change the beneficiary, you can change the owner of the account, or you can just simply move the money into a 529 account. We're going to go over all those details so that you can see how flexible this could be. But what you could do, I could establish this account for my son, and then the money can grow, grows for him, he reaches the age of 30.

We could easily change the beneficiary on the account to be his son if he had a son at that time. Or easiest of anything, we could just move it into a 529 plan. And now we have a massive, massive flexibility in who can be the beneficiary of the account.

And this is one of the areas that these Coverdell accounts are incredibly valuable, is they're incredibly valuable if you're doing multi-generational planning. And you should be doing multi-generational planning for yourself. You should be thinking about your great-grandkids. I think about it in terms of five generations. I think, "What can I do for my family in five generations?" For me, a big part of that is, "How do I live a life that's worthy of respect?

How do I train my children in such a way that they're going to train their children?" But I also recommend consider it financially, because all of the great... The Rothschild family at one point was started by one person who built an empire for his family. So just consider that.

And I don't personally care that much about the financial empire, but you may. And so I would encourage you to consider that. Next here, what is an eligible education institution? So it says here, "Qualified education expenses are the expenses that are required for enrollment or attendance at an eligible educational institution." What is that?

Well, "For the purposes of the Coverdell Educational Savings Account, an eligible educational institution can be either an eligible post-secondary school or an eligible elementary or secondary school." An eligible post-secondary school. So college, what is an eligible college? "This is any college, university, vocational school, or other post-secondary educational institution which is eligible to participate in a student aid program that is administered by the U.S.

Department of Education. It includes virtually all accredited public, non-profit, and proprietary, privately owned, profit-making post-secondary institutions. The educational institution should be able to tell you if it is an eligible educational institution. Certain educational institutions located outside the United States also participate in the U.S. Department of Education's federal student aid programs." So with regard to what college or eligible post-secondary school, it's an incredibly broad definition, which includes vocational schools, which includes many, many different types of schools.

The primary thing that is probably the most important thing for you to recognize is that it's an institution which is eligible to participate in a student aid program administered by the U.S. Department of Education. So if you're thinking, "Well, will this apply to this school?" Ask yourself that question.

Easiest is call them and ask them, and they can tell you. Now, what about for non-college schools? What about elementary or secondary schools? Well, what is an eligible educational institution that is an eligible elementary or secondary school is any public, private, or religious school that provides elementary or secondary education, defined as kindergarten through grade 12, as determined under state law.

That's very important. So first, mainstream. If your child is in a public school or you desire to send your child to a private school of some sort, doesn't matter whether that's religious or non-religious, any public, private, or religious school, you can use the money in this account for qualified expenses from that eligible educational institution.

Now, many of you know that I am personally not really planning or in favor of sending my children to a large, normal, mainstream public or private school. It doesn't really strike me as being that great of an option. So, what about homeschool? Well, that's why the state law question is important.

So the IRS publication here says, "Any elementary or secondary education, any school that provides elementary or secondary education as determined under state law." So what about homeschool? Well, here is where the state law is important. You need to consider what state you are in. Different states have different laws regarding home education and how that is established and whether or not a homeschool environment is considered to be a school, whether a home educating environment is considered to be a school or not.

And so, one of the key things that you want to think about is, "What state am I in?" If you live in a state that defines a homeschool as a private school, then you can use the money in this account to pay for eligible expenses for your child's homeschool.

That can be very useful to some of you. The states that are on the list currently are Alabama, California, Illinois, Indiana, Kansas, Kentucky, Louisiana, Michigan, North Carolina, Nebraska, Ohio, Tennessee, and Texas. I think that's, what, 14 states? So if you are in one of those states, then you can just simply pay for all of your homeschooling expenses out of this account.

Pay attention to that. That can be very useful to you. Some states have a rule where if there's a group of homeschoolers that meet together, they would call that as a private school. There are five of these states. So these five states would be Colorado, Florida, Maine, Virginia, West Virginia, and Utah.

If you are in one of those five states, those five states recognize groups of homeschoolers as private schools, but individual homeschools do not qualify under this rule. So what you would want to do in those schools, in those states, is you would want to ask yourself, "Am I part of a homeschool group?

And if not, is there a homeschool group that I could be a part of that would then entitle me to be able to use this account to pay for the eligible expenses and avoid the tax on those expenses?" So I would encourage you to check that out in your state and figure that out in your situation.

I forgot one note. In some states, the first 14 states I listed, there are more where more than one option is provided. The homeschooler may use the educational savings account only if they operate under the option which establishes the homeschool as a private school. So check your state law.

That can be very valuable to some of you. Many of you, however, will not live in those states, and that is something that you just want to consider. So that's a big deal for you as far as homeschool. So what is an eligible expense that can be paid for with this health savings account?

What would that be? What would the examples be? Well, it's different depending on whether we're talking about higher education, college, or elementary and secondary education expenses. If we're working in higher education, here are the expenses that are qualified for the tax-free treatment of distributions from the account. Qualified higher education expenses are expenses that are related to enrollment or attendance at an eligible post-secondary school, that list that we just said, as shown in the following list.

To be qualified, some of the expenses must be required by the school, and some must be incurred by students who are enrolled at least half-time. So there's a difference. Some of these expenses must be required, and some must simply be incurred. So let's start with this, with the ones that must be required.

These expenses must be required by the school for enrollment or attendance of the beneficiary at the school in order for them to be eligible expenses. Tuition and fees, and books, supplies, and equipment. So any tuition or fees or books and supplies and equipment that are required by the school can be paid for out of this account tax-free.

Next, expenses for special needs services needed by a special needs beneficiary must be simply incurred in connection with enrollment or attendance at an eligible post-secondary school. So if you are in a special needs scenario, expenses for special needs must simply be incurred in connection with enrollment or attendance at an eligible post-secondary school.

Number three, expenses for room and board must be incurred by students who are enrolled at least half-time. And half-time is defined as a student that is enrolled for at least half the full-time academic workload for the course of study the student is pursuing as determined under the standards of the school where the student is enrolled.

Remember, this is all college. This is not elementary and secondary expenses. So the expenses for room and board must be incurred by the student if they're enrolled at least half-time. And the expense for room and board qualifies only to the extent that it is not more than the greater of the following two amounts.

A, the allowance for room and board as determined by the school that was included in the cost of attendance for federal financial aid purposes for a particular academic period and living arrangement of the student. Or B, the actual amount charged if the student is residing in housing owned or operated by the school.

So let me give you some plain language on this. Your student, your child may or may not, if they go to college, they may or may not choose to stay on campus. So question, is it permissible that you can purchase a house and have your child pay the mortgage and rental cost for the house, let's say you own a house, and you desire for your child to rent the house from you while they're at school so that you can take the income from that, pay it tax-free out of your educational savings account and collect it in terms of your rental house?

Well, maybe. But you've got to follow this rule. They cannot be paying more rent than the allowance for room and board that the school says is normal for federal financial aid purposes. Or if they're paying more than that, it has to be because they are paying it directly to the school.

And then you also want to make sure anytime you're doing a transaction like that with an account that you, with a qualified account, a 529 account, something like that, you would want to make sure that whatever the rent is that they are paying would be market rent. So as an example, if the market rent for your house that you were renting out was $500 a month and your child was paying you $1,000 a month just so you could get the money out of the educational savings account, that would not pass the test.

It would need to be market rent. Always make sure, anytime you're dealing with the IRS, find out what the market price is of a certain expense that you are doing. Okay? That's college. So if you're going to pay for tuition, fees, books, supplies, and equipment, you can only pay for tuition, fees, books, supplies, and equipment that are required by the school.

So if your child wants to read a novel for fun that's not required by his or her English class, that is not an eligible expense. If the novel is required by the English class, that would be an eligible expense. Special needs services just simply need to be incurred in connection with enrollment.

They don't need to be required. And then if we're talking about room and board, that just needs to be incurred in connection with the school, but it needs to be at the rates that the school sets. That's for college. So those are the eligible expenses that are available out of the account for college.

What about for elementary and secondary education expenses? These are expenses related to enrollment or attendance at an eligible elementary or secondary school. As shown in the following list, to be qualified, some of the expenses must be required or provided by the school. There are special rules for computer-related expenses.

So there are three different sections of this, and these are very important, so pay close attention. These expenses must be incurred by a designated beneficiary in connection with enrollment or attendance at an eligible elementary or secondary school in order to be qualified expenses. Tuition and fees, books, supplies, and equipment, academic tutoring, special needs services for a special needs beneficiary, any of those are fine as long as they are incurred in connection with enrollment.

So tuition and fees, books, supplies, and equipment, academic tutoring, and special needs services. So the best example would be academic tutoring. If your child needs academic tutoring for ninth grade math, that's not probably going to be required by the school, but that is an eligible expense. If there are books, supplies, and equipment that you're buying in connection with your child's enrollment at the school, that would be an eligible expense even if they're not required by the school.

So the way that I would read that if my child were studying Spanish and they needed to purchase a set of Spanish novels to help their language comprehension, I would consider that to be an eligible expense because it's related in connection with their enrollment at Spanish class. That's useful.

Now, these expenses must be required or provided by an eligible elementary or school connection in order to be qualified elementary or secondary school expenses. Room and board or uniforms. So the example, excuse me, room and board, uniforms, transportation, and supplementary items and services, including extended day programs. So if you are concerned saying, "Well, listen, I drive my child to school every day and that costs me a certain amount in gas and whatnot.

Can I pay for that out of my educational savings account?" The answer is you can only do that if it's required or provided by an eligible elementary or secondary school. So what I would do is if I had to pay an extra fee for the bus that's provided by the school, I would pay for that out of the educational savings account.

But I wouldn't necessarily say, I wouldn't say that my school does not require me to drive my child to school. So that wouldn't pass my smell test. You would have to think through it. Or supplementary items and services, including extended day programs. If your child is required to be involved in a supplementary extended day program, then that would be something that I would pay.

But if it's simply an option that you're choosing, you can't use this account to pay for the optional afterschool care. I wouldn't consider that football practice or football fees for my child to play football. I wouldn't consider that to be an appropriate expense because it's not required by the school and that's a supplementary item or service.

So those are the first two and they're important. The first section, tuition fees, books, supplies, equipment, academic tutoring, and special needs services. They don't have to be required by the school, just simply incurred in connection with enrollment. However, room and board, uniforms, transportation, supplementary items and services have to be required or provided by an eligible elementary or secondary school.

The other example, I skipped over room and board, but I would use this as an example of the difference between boarding school versus the school around the block. If my child were in school around the block, then it would not be appropriate for me to pay myself rent. Say the child owes me a market rate of rent in exchange for the room that they're staying in, that is not an appropriate expense.

But it might be an appropriate expense if my child is going off to boarding school, excuse me, it would be an appropriate expense because it's provided by the school and now I could pay for that expense out of my educational savings account. Now the third category of eligible expenses is very interesting.

And this is basically with regard to computers. And this is different of whether your child is in elementary or secondary school or whether your child is in college. So number three, eligible expense. The purchase of computer technology, equipment, or internet access and related services is a qualified elementary and secondary education expense if it is to be used by the beneficiary and the beneficiary's family during any of the years the beneficiary is in elementary or secondary school.

This does not include expenses for computer hardware designed for sports, games, or hobbies unless the software is predominantly educational in nature. This one may be useful for many of you. If you have purchased for your child a computer or computer equipment or internet access and related services in connection with their enrollment at an elementary or secondary school, then in my opinion, that would be a qualified expense.

And to me, it seems pretty clear. So if you've purchased or are planning to purchase a computer for your child, then I would encourage you to consider this. Now, what is a computer? Well, I would bet, I don't know that the IRS has issued guidance, I haven't found any, but many students, that would be a desktop.

Some students, that would be a laptop. Some students, that would be an iPad. Maybe that would be an iPad mini. Internet access, make the choice. I personally, if I were going to do this, if my child were having a cell phone and they were using that as internet access, I would use them having an iPad mini or something with a data connection.

I guess that's changing in the world of the iPhone 6. But to me, as long as that's predominantly used for educational expenses, and for predominantly educational nature, not for sports, games, or hobbies, then to me, that would be valuable. So if you're buying a computer and it does not have to be for the exclusive use of your one child, it specifically says here that it has to be used by the beneficiary and the beneficiary's family during any of the years the beneficiary is in elementary or secondary school.

So this is a big one because in business tax deductions, one of the things that's very important is if I have a business computer that I keep in my office, I must not allow my children to play computer games on that business computer, or I will not be able to deduct the full cost of the computer.

I would have to do a pro rata deduction based upon some formula of how much they're using it for their personal use or for their business use. I must not deduct a computer if I'm using it for personal purposes. It has to be for business purposes. But that's not the case here with regard to using the educational savings account to pay for computer expenses.

That can be very useful to you. Now, what if your child is in college? Well, it clearly says here, in the language from the publication from the IRS, clearly says here, "During any of the years the beneficiary is in elementary or secondary school." So you need to be careful here.

If you're going to use this account, if the college requires your student to have a computer, pay for that computer out of the educational savings account because it would be required by the college, which would in the previous section fall in under the following expenses must be required for enrollment and its book supplies and equipment.

So a computer would be equipment that's required for enrollment. If your kid just wants a fancy new MacBook just because they're going to school, but the school doesn't require them to have a computer, then I would say that that would not be an eligible expense. Think that out carefully.

Now, when you get to the topic of expenses from an account, you get to some interesting timing ideas. And I want to talk with you for just a moment about the timing of expenses. This is useful. And there are some things that you always, when people are very proactive about tax planning, and if you're looking for ways to exploit things, by the way, the average person isn't organized enough around their expenses to be able to know how to do this.

But you can be. There's a difference between when the money comes out versus when the expense has to be incurred. You don't have to necessarily use the money from a Coverdell account in order to pay the specific expense at the time that you take it out. But you do need to have the same expense in the same year that you take a withdrawal.

So as an example, let's say that you have one of these Coverdell accounts and you're going to take the money out and you need to do something like buy a car for your child. And your child is going to school in the fall, but it's January and they think that they're going to actually need to buy a car.

Well, in January, you can take $5,000 out of the Coverdell account and you can simply use the money to buy a car for the student, for the beneficiary. That would not be a qualified education expense. But in, say, September, when they enroll at university, you go and you take out a student loan in order to pay the $5,000 in tuition for the beneficiary of that account.

And in that scenario, the February withdrawal would be tax-free because the expenses came in the same year, even though you didn't directly use the money for the tuition payment. That can be a useful planning tip for some of you, so pay attention to that. If you need to, go back and listen to it again.

It can be very useful. Anytime we're dealing with distributions, if we can adjust, and we'll get to contributions in a minute, but if you can adjust timing and distributions, that in some scenarios can be useful for you, so pay attention. I think I would be careful here to make sure this happens in the same calendar year.

I can't prove this to you, but I would be careful to do this in the same calendar year. Even though the specific connection of an expense to a distribution is not required, I would be nervous about, in, say, November, taking a distribution to buy the car for my child, and then in January, going ahead and enrolling in tuition.

I wouldn't do that. I would keep them in the same calendar year to keep things clear. Now, what if you take a distribution from the account, and you're not in a scenario where you're able to take that and actually pay the tuition? Let's say that you take a distribution in January to cover—January 1st, you take a distribution for the Coverdell account to cover your child's spring and fall tuition payments, but you find yourself in a scenario where you are unable to—for whatever reason, your child goes to school in the spring and then decides to take off for Europe, and they don't re-enroll in the fall.

So now, you maybe took $5,000 out of the account, and you were planning to pay it on tuition, but now you don't have a qualified thing that you can do with it. What do you do? Well, here's an easy way to avoid that one. It's just simply put the money into a qualified tuition program account, aka a 529 plan.

So just simply open a 529 plan and contribute it into a 529 plan with a beneficiary for the same beneficiary. So if you took the distribution from the ESA in January, then in December, you went ahead and made the contribution to the 529 plan, you can avoid the penalty tax on the distribution.

That may be useful to some of you or to some of you financial planners when you're in a scenario where your client has taken an unqualified distribution, and you're looking for, "How do we fix it?" Just put the money in the 529 plan. That's always your exit plan, easy, easy exit plan from an educational savings account problem.

Super easy to always just stick the money into a 529 plan. Useful. I hope it's useful to you anyway. Contributions. So how do we contribute and who can contribute? Any individual, including the designated beneficiary, pay attention to that, including the designated beneficiary, can contribute to a Coverdell educational savings account if the individual's modified adjusted gross income, which I'll define in just a moment, for the year is less than $110,000.

For individuals filing joint returns, that amount is $220,000. Organizations such as corporations and trusts can also contribute to Coverdell educational savings accounts. There is no requirement that an organization's income be below a certain level. So when I said in the beginning that the article that the guy wrote in Forbes, when he says, "Oh, Coverdell, you can't do it because you can't contribute once the parent's income is phased out after $200,000 and the 529 plan doesn't have those rules." Yes, that is correct, but it is absurdly easy to just simply get around the rule.

The easiest way, just give the money to your kid. All you need to do is just simply say, "Here, son, here's $2,000." Now, you have your son stick the money into the account. As long as your son doesn't make more than $110,000, that's easy to do. Now, if your son does make more than $110,000, what do you do then?

Well, just take the money out of your company. Take the company, make the contribution from the company. It doesn't matter whether your company makes $10 billion a year. There is no requirement that an organization's income be below a certain level. You could do this with a corporation. You can also do it with a trust.

Organizations such as corporations and trusts can also contribute to Coverdell educational savings accounts. There is no requirement that an organization's income be below a certain level. Again, why do politicians bother with this stuff? I don't know, but they go back and fix the law. What's the point of having an income limitation when it's that easy to get around?

It's what happens when people don't have a clue what they're doing, write laws. This opens up, however, some interesting planning ideas in my opinion, is that with regard to who can contribute, and then also we're going to get in just a second to the timing of the contribution. When you get to who can contribute and you open up the world of people being able to contribute who are businesses, for many of you who make a lot of money, this is all you need right here, is just use the money out of the business.

Now, again, is $2,000 really going to make a big difference to you? No, it's not really going to make that big of a difference, but it's better than nothing, and especially when you get to what can you invest it in, you could do some interesting stuff with this. But with regard to using a business, this can open up a lot of things.

So could you use this as a simple bonus program for yourself? Yes. If you make over $110,000 a year as an individual or $220,000 a year filing jointly, just simply bonus yourself the money out of your company and stick it into the ESA, and you can do this $2,000 each year for each of your kids.

And whatever growth you get on that account, that will save you on the cost of the tax. Now, it's not going to save you on some of your taxes, so it's not going to save you on employment taxes. This is still going to be wages. Depending on the type of corporation that you own, that's going to dictate what type of distribution this is.

I'm not an accountant. Talk to your CPA or to your accountant about this question. If I were doing it for myself, if I owned an S corporation, then I would do this either as a shareholder distribution on $1,120,000 or as a non-deductible expense. So I would do this as either of those.

They're both taxed the same. Those are wages, so you're going to pay the taxes on them. It doesn't save you on your employment taxes. But you could also set this up from the perspective of your employees. So if you wanted to use something like this as a benefit for your employees, this would be fairly easy to do.

If you want to reward your star employee, Joe, and you know that Joe has kids, all you need to do is contribute the $2,000 into his ESA for his kids. Easy to do. It may be a useful bonus program that you could set up for you. I think you could discriminate on this one.

You don't have to set it up for everything. You could just simply discriminate among employees easily without any problem there. What you would do in that situation is you would just simply record it on the employee's W-2. And this would be subject to their payroll taxes. Or you could offer it as a deduction.

So if you wanted to offer this as an option as a deduction, and then at the end of the month or the end of the year, you send it into their educational savings account, that would make it easier for the employee to fund the account and it might be useful for you.

This is not going to be a tax-free benefit to the employee. So this is not a fringe benefit that you can set up to be a tax-free benefit. So this is not being done for the savings of tax. So in many ways, I think this is relatively useless as a bonus program.

But it can be very important and helpful for you as an option to do it in your own company. So that's what I would encourage you to do. You know, I just caught myself. I'm not sure the answer. If some of you accountants could comment, if you had an S-corporation, is a shareholder distribution or a non-deductible expense, do you pay employment taxes on that money?

I'm not sure the answer. So if some of you accountants could help me out on that, I would appreciate that in the show notes. I may have made a mistake in what I just said. So come by the show, radicalpersonalfinance.com/coverdell, and let me know whether I'm right or wrong on that.

I would assume, because it's not deductible for the employee, I would assume that would be applied also to an S-corporation. That's where I get my logic on that. But come by and correct me. So hopefully that's helpful as far as contributions, is that that can be very useful to many of you as far as how to contribute to the account.

And that's why even though this is another one of those things, for years I thought, "Oh, it's just about the limit." No, that limit is so bogus because it's so easy to walk around it. There are some limits that are hard to walk around. There are some limits that are easy to walk around.

Next, what is a contribution and what are the requirements of how a contribution looks? Well, the IRS says here that there are three requirements that it must meet. Number one, the contribution must be in the form of cash. So this is important because many of you, if you're looking to say, "Well, what can I fund this account with?" You must make the contribution in the form of cash.

Now, to some of you, you're not used to thinking about contributions to accounts in terms of property. But for the wealthy, this is the primary way that you think is that, "Why would you put cash when you could do property?" So you want to contribute sometimes appreciated property, sometimes depreciated property.

You want to essentially, for most of the wealthy, you're often working with property, with assets, with stock. And you're doing this so that you can retain the basis of the account or so that you can increase the basis of the account. In this situation, it's not. You must make the contributions in cash.

So if you have an investment and you want to contribute to that to an ESA, sell the investment and contribute the cash. Must be made in cash. Number two, contributions cannot be made after the beneficiary reaches the age of 18 unless the beneficiary is a special needs beneficiary. So for those of you who aren't doing special needs planning, then in this scenario, you can't put money into the account after the age of 18.

That's important. If you are doing special needs planning, this might be an important exception for you. So in this scenario, then you might be able to use this. If there's some sort of qualified educational expenses that are going to be incurred for your special needs, what's the name for the person for whom you're a guardian?

I can't remember the legal name for it. The person that you're caring for, then this can be useful for you because you can do this after the age of 18. So useful for you. This would be one of the things that the author of the Forbes article was right on.

He says, "Coverdells have time limits. They have to be started before the beneficiary turns 18 and used up by age 30." Technically, he's actually not right about that. They don't have to be started before the beneficiary turns 18. You have to just be able to put contributions in before the age of 18.

So if you have an account that, let's say, that your 30-year-old son doesn't need, but you have a 23-year-old daughter who's going to graduate school, then all you can do is you can simply transfer that account from the 30-year-old son to the 23-year-old daughter. That is entirely permissible. So they don't have to be started before the beneficiary turns 18, but they do have all the contributions have to be in by the time the beneficiary is the age of 18.

And then the last requirement for the contributions. The contributions must be made by the due date of the contributor's tax return, not including extensions. So this is useful because in the accounting world, there are certain accounts that when you're sitting there doing a client's taxes on April 14th, assuming they're not filing an extension, then there are some accounts that are easy to go to.

This is an example of why the SEP, the SEP IRA, Simplified Employee Pension IRA, is very useful to accountants. It's an accountant's best friend because you can make a full contribution of the 25% of profits on April 14th and it counts. This is why IRAs are useful. Why your accountant is always saying, "Do you want to contribute to an IRA for last year?" That you can file your taxes next year on April 14th, 2015, and you can make a 2014 IRA contribution.

You can't do that with a 401(k). Your 401(k) has to be contributed to before the end of the year. You can do that with an educational savings account. So if you get to the end of the year and you're saying, "I've got an extra $2,000 here," or, "I've got five kids, I've got an extra $10,000 here," you might consider going ahead and using an educational savings account.

This might be a good scenario for you. So consider that. Hopefully that will be helpful to you. It's nice to have these types of accounts that you can use. Additionally, you can make your contributions to one account or several accounts. As long as the same designated beneficiary doesn't have total contributions that are in excess of $2,000.

That's what I'm saying as far as you can contribute $2,000 to each of the accounts for your five kids, as long as nobody else contributes to any money to accounts for those kids. And then contributions can be made without penalty to both a Coverdell educational savings account and a qualified tuition program, aka a 529 plan, in the same year for the same beneficiary.

So if you have more money, you have one child, you have $10,000 you need to get rid of, put $2,000 in the educational savings account if you value the benefits, which you're still getting to like the investment benefits, and put the rest in the 529. That is entirely permissible.

The contributions are considered to have been made on the last day of the preceding year. So if you make a contribution in April of 2015, then the IRS considers that contribution to have been made on December 31, 2014. But it has to have been made by the due date, not including extensions, for filing your return for the preceding year.

Contribution limits. There are two contribution limits. Number one, there's one limit on the total amount that can be contributed for each designated beneficiary in any year. And number two, there's a limit on the amount that any individual can contribute for any one designated beneficiary for a year. So confusing, right?

Doesn't make any sense. So again, why is this law written this way? You would think that the person writing this law would sit and say, "Let me make this less confusing." But this is—it's utterly silly. But the rule is that no individual can set aside more than $2,000 for a beneficiary, and no beneficiary can have more than $2,000 set aside for them.

So if—the way the law is written, it doesn't matter who the person contributing is. So I have—let's say, pretend I have a son named Joe. I could put aside $2,000 for Joe, the way the law is written. My company or my wife's company could set aside $2,000 in an educational savings account for Joe.

And Joe's grandmother could set aside $2,000 in the account for Joe. Now, each of those accounts would accept the money, but the IRS doesn't want that to happen. So we can't set aside—Joe can't have more than $2,000 set aside for him, period. So I can't put aside $2,001 for him, but if I set aside $2,000, no one else can put aside $2,000.

And so they've tried to fix this in the way they set up the forms, but you don't actually have to use the forms when you set up a Coverdell account. Most banks and brokerage accounts and companies are going to use the IRS forms. But the key is that different people could do different contributions to the account, and no one could know.

They could not tell. So if my grandfather—my father sets something up for my son, unless he tells me, I don't have any knowledge of it. And so this is a real pain, and that's why there are those two rules that are specified. It's a real pain. You've got to make sure that no more than $2,000 gets set aside in that account.

And if we find out that more than $2,000 has been set aside, then we've got to pay the 6% excise tax, which we'll get to in a minute. So big deal. Make sure that no more than $2,000 is set aside for any individual beneficiary, regardless of the number of accounts and regardless of the number of account holders.

If you're going to put in $500 and Grandma's going to put in $500, make sure that Aunt Susie only puts in $1,000. She can't do her own account for $2,000. So hopefully that helps as far as the contributions. Next, what is that number, the modified adjusted gross income? You'll hear this number in financial planning a lot of times, and this one always bugged me because I can never figure out what is modified adjusted gross income.

I tried to look at the tax return, and I'm saying, "Where is this MAGI number?" You have the AGI number. That's easy to find, adjusted gross income. What is a modified number? And the best I've been able to figure out is that basically the IRS tosses this number in, and they modify the adjusted gross income number for whatever the planning is that they're doing.

And so with regard to the Coverdell account, then basically for most people, the modified adjusted gross income is exactly the same as the adjusted gross income. But if you are using a 1040, then for the purposes of that number, the $110,000, $220,000 number, the modified adjusted gross income number is your AGI, and then you add back any foreign earned income exclusions that you have, any foreign housing exclusions that you have, any foreign housing deductions that you have, any exclusion of income by bona fide residents of American Samoa, and exclusion of income by bona fide residents of Puerto Rico.

So if you are in one of those scenarios, you're doing something foreign, or you are in American Samoa or Puerto Rico, then you need to be careful about making sure that you use that modified adjusted gross income number. That would be important for you. Theoretically, I don't see any reason why this account can't fund some foreign adventure travel for you.

So if you're putting in your kids into a school in Colombia while you're living down there, I don't see any reason. And it's a private international school. I don't see any reason, as long as that school matches the elementary and secondary numbers, I don't see any reason why you can't use this account to do so.

What if you put too much money into the account? So let's say that you run into the problem with the contributions, and you just wind up putting too much money in the account. What happens and what do you do? Well, in that scenario, you have excess contributions, and you're going to pay an additional tax.

Very nice of the IRS to call it an additional tax. I call it a penalty. It's an additional excise tax. So the beneficiary, beneficiary, yes, your one-year-old child, must pay a 6% excise tax for each year on excess contributions that are in a Coverdell Educational Savings Account at the end of the year.

Excess contributions are the total of the following two amounts. One, contributions to any designated beneficiary's Coverdell Educational Savings Account for the year that are worth more than $2,000, or if less, the total of each contributor's limit for the year as discussed earlier. Or two, excess contributions for the preceding year reduced by the total of the following two amounts, distributions during the year, and B, the contribution limit for the current year minus the amount contributed for the current year.

So that's mumbo jumbo, but that's the important thing you need to know. Let me make it simple. If you put too much money in the account over the $2,000 and you didn't take it out, you owe a 6% excise tax on the money. Now, I always like to think, when I'm going to pay a penalty tax, is there a way I could make this work?

Not sure, but what if your returns were way in excess of 6%? Theoretically, I bet you there's a planning idea there. I created a couple scenarios that I thought, "I wonder if I could do this?" This would not apply to 99.999% of you, but you financial planners out there, think that through and see if there's a way that you could take advantage of that 6% number.

But let's go on. The excise tax does not apply if the contributions are made during 2013—this is the year I'm reading the 790 from—and distributed before the first day of the sixth month of the following tax year. So you've got to get it out before the sixth year, and you have to include any of those excises in your income.

So that's a useful thing, and there actually is a planning opportunity there. Going back to the timing of the contributions, one of the things that you could do when you get to the investment opportunity—some of you guys who are super intense with this stuff and willing to take it on—and when you get to the idea of saying, "Could I invest in a rental house through this account and use that, or could I buy an option that is going to be a useful option?" You can take advantage of the timing flexibility of when your contributions versus your money coming out, and you might even be able to take advantage of the float that's there versus putting the money in and taking it out.

That was the planning idea that I was trying to work out. Again, this is a tiny percentage of the population that could ever come up with something like this as far as it being applicable, but theoretically, I think there's an idea there. We've gotten the basics of the account squared away, and we've said, "Okay, now I've got money in the account.

We've got our contributions in there. We've got our money growing. I'm going to deal with investments after I deal with getting the money out." So let's talk about what do you do with the money now that it's grown and you need to get it out. So you have some questions of, "If I have educational expenses, that's easy.

We just pay for the educational expenses. You get the money out of the account. You've got to get it out by the time you're 30, but what if you save too much or what if something changes and you don't have the expenses there? What do you do with the money?" So here we get into the world of rollovers and transfers, and there are a couple different ways to do this.

You can do this with rolling the money into a new account for a new beneficiary, or you can do this with changing the beneficiary. So assets can be rolled from one Coverdell educational savings account to another, or the designated beneficiary can be changed, and the beneficiary's interest can be transferred to a spouse or former spouse because of a divorce.

So there's a lot of flexibility here, and I'm going to walk you through these numbers. The most useful one in practical everyday planning scenarios is going to be family members. Any amount distributed from a Coverdell ESA is not taxable if it is rolled over to another Coverdell ESA for the benefit of the same beneficiary or a member of the beneficiary's family, including the beneficiary's spouse who is under age 30.

This age limitation does not apply if the new beneficiary is a special needs beneficiary, because it can be done for later, even after the age of 30 if you're dealing with special needs. Pay attention, those of you who are doing planning for special needs people, or you are the custodian of a special needs person.

An amount is... I wish I could come up with a legal term for that. Someone comment on the show notes and tell me what it is. The person for whom you're a guardian. An amount is rolled over if it is paid to another Coverdell educational savings account within 60 days after the date of the distribution.

So, planning idea. One of the things that I do not think was addressed... The other day on the show, I talked about the Bowbrow case, where the exclusion for IRAs was dropped to one IRA per year, instead of the former amount where when you're doing a transfer from one IRA to another IRA, you can basically have the 60-day window of free money.

Now, you can basically do that same thing, even though we're limited on accounts, like limited with IRAs, you can do that same thing with an ESA. So, if you have a short-term... Let's say you have a bunch of money in your kid's educational savings account, and you have a short-term emergency, or you have a short-term cash flow need, you can take the distribution from one Coverdell educational savings account.

You have use of the money for 60 days, and then you've got to make sure the money gets put into another account within another 60 days. So, if you're ever in the need, or if you planners are in the need for a client and then basically need short-term money, you may be able to use this as a 60-day gap loan, because we have the same scenario that we can do with IRAs, where we've got that 60-day limit.

We can do that here with the educational savings account as well. Useful tip for you planners, especially, because you wind up with a client in this scenario. So, if a client has an ESA, it may help you. The IRS says, "Do not report qualifying rollovers, those that meet the above criteria, anywhere on Form 1040 or 1040NR.

These are not taxable distributions." So, if you do a qualified rollover in the way that I just said, you don't have to report it on the 1040. That's useful. Now, you're doing a rollover from one account to another, and you're changing the beneficiary. Who is the IRS define as members of the beneficiary's family?

For these purposes, the beneficiary's family includes the beneficiary's spouse and the following other relatives of the beneficiary. Remember, the beneficiary has to be under the age of 30, so that is a limitation, or has to meet special needs. But if that counts, then we can use this account. It can be a number one son, daughter, stepchild, foster child, adopted child, or a descendant of any of them.

I'm going to pause here for a moment. That descendant is so important, because remember, in the beginning, when I talked about the limitations of this account, when we're talking about the fact that, "Well, it's not useful because you have a limited planning time horizon," we can use this for descendants.

So, for some of you, that means you're not thinking about your kids. You're thinking about your grandkids. So, it may still be valuable for you if you have the cash flow to fund this kind of account, because when we can stretch the time horizon out, now we wind up with a much more useful scenario.

And it says, "or a descendant of any of them." I interpret me personally, as a layperson, I interpret "descendant" to mean any descendant, including your grandkids' grandkids. Now, in this scenario, we'd probably want to have a little bit more control. So, we'd probably want to move into the setting up a trust, maybe some sort of dynasty trust, that would be a little bit more controlled.

But, it's a tool that you might be able to find useful. Let's say that you could set aside $2,000 into an educational savings account. And for the purposes of my example, let me use, let's say I put in $2,000 as my payment. And what I'm going to do is I'm going to pretend that you start this with your zero-year-old child, right when they're new, and you put in $2,000 per year.

And you have 18 years into which you can make contributions. Then the account sits, and I'm going to assume that you have a younger child, so you can contribute to that one. And then you're going to flip these before the child is 30 to your grandchildren. So, in my scenario, just to give you some math on how this can be more valuable for you, assuming tax law doesn't change, under this law, you could use the ESA in this way.

So, again, I'm dealing within the constraint of the beneficiary has to be under 18. So, I need one child to start it with, then I need another child who's under 18, but to show you the mathematical power, if you can extend this out. So, $2,000 per year, let's say I can make contributions to this account up through the age of 30, so, excuse me, for the next 30 years.

And let's say I use a 10% number for my nominal investment return, and let's start with $0. Well, now in this scenario, now I've got $361,000 in this educational savings account, and I contributed 30 times $2,000, I contributed a total of $60,000. So, now I have $300,000 of tax-free gain built up that I can distribute for my grandkids, for my kids, and for my grandkids' college education, or for their family.

That's a much bigger deal, which is what, now, you can also do that with a 529, but when we get to pay attention to the investment restrictions of the 529 plan, whereas with the educational savings account, you don't have the investment restrictions that a 529 plan has. So, that's a big deal, it's a very big deal.

Members of the beneficiary's family. So, these can include the beneficiary's spouse and these relatives. I'm going to go through the full list now, and look how useful this could be for some of you when you're thinking about your great-grandkids and kind of your dynasty as a family. Beneficiary can be changed to any of these people.

Son, daughter, stepchild, foster child, adopted child, or a descendant of any of those people. The beneficiary's brother, sister, stepbrother, or stepsister. Father or mother or ancestor of either. Stepfather or stepmother. Son or daughter of a brother or sister. Brother or sister of father or mother. Son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, or sister-in-law.

The spouse of any individual listed above, or the first cousin. We've got to deal with the age restriction, but basically anybody who's even remotely related to or married into the family, we can use this account to benefit them. And then remember, we can always get around the age restriction by dumping the money into a 529 plan.

So, we can always use that as our exit. Really, really useful. So, I think this is an underappreciated tool, especially when we get to the idea that we can fund this with non-traditional investments. We don't just have to choose the mutual funds that the state approves to offer in their 529 plan or the prepaid tuition 529 plan.

We can fund this with real estate, we can fund this with business interests, we can fund this with some more exotic investments, to the best of my understanding. For those of you who aren't that exotic, all this means is that you can just use the money for your kids.

Just set it aside for your oldest child, and then if your oldest child doesn't use it, you can transfer it down, you can transfer it down, you can transfer it down. So, I leave you just to think about that, and you planners, think about the opportunities. I've never seen anybody write much about this, but to me, unless I've missed something totally wrong and tell me if I have, this is an underappreciated issue, because everyone gets so focused on the $2,000.

I say, focus on the $2,000 and fund it with some investments that you can't hold in the qualified tuition program. So, one key note, only one rollover per Coverdell educational savings account is allowed during the 12-month period ending on the date of the payment or distribution. Now, another special planning note, right here in the 970, or 790, what's this, 970 or 790, it's one of these publications, I'll list it in the show notes.

This rule does not apply to the rollover of a military death gratuity or payment from service members group life insurance. So, if any of you financial planners that are working with military members, if your military client, or any of you who are in the military, if your military client has service members group life insurance, there is a planning opportunity here.

Let me read this to you. Military death gratuity, if you received a military death gratuity or a payment from service members group life insurance, SGLI, you may rollover all, or part of the amount received to one or more Coverdell ESAs for the benefit of members of the beneficiary's family.

Such payments are made to an eligible survivor upon the death of a member of the armed forces. The contribution to a Coverdell ESA from survivor benefits received cannot be made later than one year after the date on which you received the gratuity or SGLI payment. This rollover contribution is not subject to, but is in addition to, the contribution limits discussed earlier under contribution limits.

The amount you rollover cannot exceed the total survivor benefits you received reduced by contributions from these benefits to a Roth IRA or other Coverdell educational savings accounts. The amount contributed from the survivor benefits is treated as part of your basis in the Coverdell ESA and will not be taxed when distributed.

The limit of one rollover per Coverdell ESA during a 12-month period does not apply to a military death gratuity or SGLI payment. So if you're working with a military member who has died and you have an SGLI payment, consider that you can get a lot of money into an educational savings account.

Hopefully the military member has lots of life insurance. If they were my client, they would have lots of life insurance. Use the other life insurance, not the SGLI insurance, to cover the needs of the family and make sure that SGLI payment gets into an educational savings account. You don't have to be capped at the $2,000.

And consider the power of this from the perspective of a dynasty. Take the idea of a dynasty trust without all of the hassle of setting one up and consider that with just a simple educational savings account, you can put in all the insurance money, lump sum, and it can be passed down through the generations, always tax-free with a simple Coverdell educational savings account.

Useful. Now, next section, changing the beneficiary. The designated beneficiary can be changed. So there are no tax consequences if at the time of the change, the new beneficiary is under age 30 or is a special needs beneficiary. So instead of saying, "Okay, I'm going to roll over the money from one account to another because my child grew to be over the age of 30," you can just simply change the beneficiary for the account.

And that's really, really useful. Or you could, very, very simple. Transfer because of a divorce. If a spouse or former spouse receives a Coverdell educational savings account under a divorce or separation instrument, it is not a taxable transfer. So for those of you financial planners working in the case of divorce, there's no taxable transfer.

We would assume that anyway, but just pointed out as it's useful. Distributions. The designated beneficiary of a Coverdell educational savings account can take a distribution at any time. That's useful. You can take a distribution at any time. That's a problem sometimes when you're dealing with 401(k)s account, things like that, where you can't take a distribution anytime.

You can from IRAs and Roth IRAs, but you can take a distribution at any time from the ESA. But whether the distributions are tax-free depends in part on whether the distributions are equal to or less than the amount of the adjusted qualified education expenses defined later that the beneficiary has in the same tax year.

So we've got to look at the same tax year. And that's why I say be conservative with this in the same calendar tax year and make sure that the amount of whether it's distributed. That was where that idea about it doesn't have to be forward, it just has to be in the same tax year.

So what are the adjusted qualified education expenses? To determine if total distributions for the year are more than the amount of qualified education expenses, reduce the total qualified education expenses by any tax-free educational assistance. Tax-free educational assistance includes these items. So you take what are the total expenses and then you take out any of the tax-free basically educational assistance, one is scholarships, that you've received.

The tax-free stuff. And so here are the line items. The tax-free part of scholarships and fellowships, veterans educational assistance, Pell grants, employer provided educational assistance, any other non-taxable tax-free payments other than gifts or inheritance received as educational inheritance, as educational assistance. The amount you get by subtracting the tax-free educational assistance from your total qualified education expenses is your adjusted qualified education expenses.

Generally your distributions are tax-free if they are not more than the beneficiary's adjusted qualified education expenses for the year. Do not report your tax-free distributions on your tax return. A portion of the distributions would generally be taxable to the beneficiary if the total distributions are more than the beneficiary's adjusted qualified education expenses for the year.

And the publication goes into how to calculate that. It's not important for the purpose of this podcast. If you're in that scenario, you can calculate that difference. How about coordination with the American Opportunity and Lifetime Learning Credits? The American Opportunity or Lifetime Learning Credits can be claimed in the same year that the beneficiary takes a tax-free distribution from a covered out ESA, as long as the same expenses are not used for both benefits.

This is the the doctrine that applies to all of these credits and all of these distributions, whether it's 529 coordinating 529 distributions, or as the IRS would call them, the Qualified Tuition Program distributions, coordinating it with credits. You cannot take $10,000 of college expenses, take an American Opportunity Credit or a Lifetime Learning Credit, and then pay for all $10,000 out of a Qualified Tuition Program and pay all $10,000 out of your educational savings account.

Doesn't work. But if you use $4,000 on one and $6,000 in the other, you can do that. That's the basic doctrine. You don't need to know anything else, at least for now. If you need more details because you're an accountant, check the publication. What about losses on the account?

This will be useful to some of you. What about losses on the account? Well, if you have a loss on your investment, many people forget about the fact that they can claim losses on certain tax qualified accounts. You can claim losses on IRAs. How does it work? What about if let's just stick with covered out ESAs.

If you have a loss on your investment in a covered out educational savings account, you may be able to deduct the loss on your income tax return. You can deduct the loss only when all amounts from that account have been distributed and the total distributions are less than your unrecovered basis.

Your basis is the total amount of your contributions to that ESA. And you claim the loss as a miscellaneous itemized deduction on Schedule A of your 1040, and it is subject to the 2% of Adjusted Gross Income limit. So that is a key useful one. I don't want to go deeply into losses, but some of you who are really good with these numbers are immediately seeing the options.

Ah, so put the money in the ESA, and let's see what happens with the investments. If the investment grows, great. It's a benefit because I can use the money and the growth tax-free for the tuition. If I have a loss, I can go ahead and deduct the loss. I didn't lose the ability to deduct the loss, but it is subject to the Schedule A miscellaneous itemized deduction, and it's subject to the 2% of AGI limit.

So that is a...it's just a fact. That's how it is deductible. Additional tax on taxable distributions. So if you take a distribution from it, and you don't have it, it's a taxable distribution because you don't have a qualified education expense, what happens? 10% penalty tax on the amount that's included in the income.

So you get that 10% tax just like you do from the IRA or from the Roth IRA. What about exceptions? Well, there are some exceptions. So what would the exceptions be on this account? How does this work? Well, the 10% additional tax does not apply to distributions that are, one, paid to a beneficiary or to the estate of the designated beneficiary on or after the death of the designated beneficiary.

Useful. So if the beneficiary dies, then there's no 10% additional tax. Number two, distributions that are made because the designated beneficiary is disabled. A person is considered to be disabled if he or she shows proof that he or she cannot do any substantial gainful activity because of his or her physical or mental condition.

A physician must determine that his or her condition could be expected to result in death or to be of a long continued indefinite duration. I read that as basically equivalent to the Social Security definition of disability. So those of you who are familiar with that, that's how I read that.

Number three, included in the distribution, the additional tax doesn't apply to a distribution if the distribution is included in income because the designated beneficiary received a tax-free scholarship or fellowship, veterans educational assistance, employer-provided educational assistance, or any other non-taxable tax-free payments other than gifts or inheritances received as educational assistance.

So the way I read this and the way I understand this law to be, if the money comes into and becomes a taxable distribution because you received other scholarship, income, veterans educational assistance, employer-provided educational assistance, or other tax-free payments, then you don't pay the penalty. You're just going to pay the income tax.

It's a taxable payment, but you don't pay the 10% penalty. Additionally, the 10% additional tax does not apply to a distribution that is made on account of the attendance of the beneficiary at a U.S. military academy. This exception applies only to the extent that the amount of the distribution does not exceed the cost of advanced education as defined in this section of the code attributable to such attendance.

So if you're going to a U.S. military academy and thus there's a distribution and a distribution is not in excess of the costs that are defined in that certain amount because the cost, as I understand this, the costs are underwritten by the government, then there's not the penalty. And then number five, included in distributions, you don't owe the 10% tax on any distributions that are included in income only because the qualified education expenses were taken into account determining the American Opportunity or Lifetime Learning Credit.

So the way this works, let's say you only have $10,000 of expenses and you use that $10,000 of expense and it's used to take the American Opportunity Credit or the Lifetime Learning Credit. Well, now you can't double count that, but you can go ahead and get money out of the account.

It's going to be a taxable distribution, but you're not going to owe the penalty. And then finally, number six, the 10% additional tax doesn't apply if the distribution was made before June 1, 2014, because that's the last year's publication I'm reading. I assume this is every year. So if the distribution is made before June 1 of an excess 2013 contribution and any earnings on it, but you do need to include the earnings in your gross income for the year in which the excess contribution was made.

So you would file an amended 2013 return. Could be useful. It's a lot. I told you this is going to be heavy, but we're about done. We're almost done with this publication and we're going to get to investments, but you need this background because if you understand this background, then you can understand, "Ah, I see.

Here's how these different things could work together." Next, when must the assets be distributed? Any assets that are remaining in the ESA must be distributed when either one of these events occurs. The designated beneficiary reaches age 30. In this case, the assets must be distributed within 30 days after the beneficiary reaches age 30.

However, this rule does not apply if the beneficiary is a special needs beneficiary. So if you're, again, special needs, this may be useful for some of you. Number two, the designated beneficiary dies before reaching age 30. In this case, the remaining assets must generally be distributed within 30 days after the date of death.

So that's the key. If it's still in the account, it's got to get out at 30, but remember, you can just change the beneficiary or transfer the role over the account. If a Coverdell, there's an exception, if a Coverdell educational savings account is transferred to a surviving spouse or other family member as the result of the death of the designated beneficiary, the Coverdell ESA retains its status.

This means the spouse or other family member can treat this Coverdell ESA as his or her own and does not need to withdraw the assets until he or she reaches age 30. We already know that. So that is a useful scenario, and that's the IRS publication, and you need that background in order to properly interpret some of the other options.

So you need that background. Now, there are some other additional issues that this brings up from a financial planning perspective that you need to be aware of, and none of these fit into a four-bullet-points comparison of the ESA versus the 529. So consider these scenarios. First of all, what about the issue of control?

I won't go deeply into this, but one of the things that we're always dealing with when we're dealing with tax advantaged accounts to transfer money for kids' benefits is who has control. So the example would be something like a UTMA account, a Uniform Transfer to Minors Act, or UGMA, Uniform Gift to Minors Act.

Then in this scenario, if you're having this issue with the control, then—excuse me, I got tongue-tied there—the issue is that those accounts eliminate the control of the donor to the account once a certain condition is met. So usually, I'm not a fan of UTMAs or UGMAs, as we call them, because the donor has no control over it.

And this is a real problem, because if your kid's on drugs and is making a mess of their life, you don't want them to inherit $100,000 or $400,000 at that age. You want to pull it back. But if you've done that with an UTMA or an UGMA account, then in that scenario, you've given up control.

So you want to maintain control. The 529 accounts are useful because you can easily retain control. However, the Coverdell account seems to be a little fuzzy. I don't think that it's been well litigated, and I'm careful here. My guess is that you can still—I want to be careful here.

I just want you to be aware of this. Maybe it's not been litigated that I'm aware of, and so who knows. If you're very concerned with control and being able to exercise that control, be careful. The Coverdell account must be used for the benefit of the named beneficiary, not for you, the donor, or the responsible individual.

If this is a big deal to you, I'd consider you—I would encourage you—consider the 529 account. Really, the 529 offers the ultimate level of control because there's no restrictions on your ability just to do any withdrawals or change it, make any changes. So it's a much stronger account from the perspective of control.

So that is one useful scenario. If you're a grandparent also making this kind of account, most custodians are going to require that the child's parent or guardian be the responsible individual on the account, so you might not have the same options that you would be comfortable with with a 529 account.

Be aware of that. That is an important thing in planning. Investment options. Investment options are exciting, and this is one of the things that's most exciting about the ESA. Maybe I should have put this up front. In fact, I think I'm going to go record a new intro to the show and mention this.

But the ESA is hurt because it has much lower maximum contribution limits than the qualified tuition programs, 529 accounts. The reason I do that, in case that annoys you, I try to use the proper language because people use 529 usually to talk about the 529 savings programs, and the IRS calls it a qualified tuition program, of which there are two types.

There's a 529 prepaid tuition program and there's a 529 qualified savings program. I do my best. I go back and forth because we use all this lingo, but I hope it doesn't annoy you. I try to use the qualified tuition program language that the IRS uses for clarity. What are the differences from the ESA versus the 529 as regards investments?

The big one, ESA has much lower limits, so you can't get as much money into the account as you can with a 529 account. You can only get in maybe, again, $2,000 into this account per year. Unlike the 529 where you can front load contributions and you can get hundreds of thousands of dollars in here depending on the donors and the contributions right up front, which is powerful for compounding, you can't do that with the ESA.

But the ESA allows a ton of investment choices. An ESA basically allows just about any investment. Any investment that you can use in an IRA, you can invest in an ESA. Now, for many of you, this will not matter because you're just going to buy some mutual funds and that's fine.

You can buy some great funds. You can get that in a 529, choose a good fund family, choose some low-cost funds. Super simple. Your advisor can help you. But for some of you, this will be very useful because you want to do some more aggressive or exotic investing. So you can use stocks, bonds, mutual funds, but you could also use all of the other things that you can put it into an IRA, including individual accounts, including real estate, including you can't do collectibles, but you could do options.

You could do intellectual property. You can do private investments. You can do all kinds of interesting things. And the key is that, yeah, you can only put the $2,000 in there, but you're way more flexible. You can invest in any mutual fund, any ETF, any stock or bond, or even some of the more fun options that many of you would love to be able to do.

Many of you get really upset and annoyed with, "I can only buy this mutual fund," because either you don't trust the stock market or you're a really great real estate investor or you have some notable skill or you have a personal bias in one direction or another. So I found two stories when I was researching this.

So here's how you do it. Basically, you need a custodian that's going to allow you to do this. And you're going to set this up very simply with basically setting up an LLC and then you're going to invest through an LLC. The way that I would do it is I would set up an LLC.

I would invest through that LLC and I would have that member units in that LLC owned by my educational savings account. There are lots of people. If you go online, do a DuckDuckGo search and find some people that can work with. This is specialized. I want to make you aware of the option, but you're going to want to work with an investment provider who's going to help you with this.

Shop around. There are more of them coming out. As far as how this is useful is that there are a lot of fun things that many people like to invest in that are hard to do in the traditional broker-dominated mutual fund world. So if you wanted to invest in real estate here in the US, or you wanted to invest in a real estate development project in Brazil, or you wanted to trade options, you wanted to buy and sell notes, you wanted to do liens in real estate, you wanted to own stock, limited partnership interest, different things, you can do that if you set up a self-directed account.

What you can do is with some of these custodians, what they offer is they offer you the ability to essentially merge your accounts. So you can set up a self-directed 401k, you can set up a self-directed health savings account, you could set up a self-directed educational savings account, and then you could invest in a certain investment through all of those accounts.

The key is, remember, that your funds in an ESA cannot be commingled except if it's in a common investment option. And so that's what they're doing, is helping you set that up. You need the legal structure to do it on paper, but you can do it. So I found a couple of stories as part of the sales stories, and I'm going to read you these stories that I found online just because it illustrates the point.

And supposedly, these are real stories by the custodians who are vying for your business to set this up for you. But one story says, "One client..." Okay, so, "With the small contribution limits for Coverdell ESAs, you might wonder how these investments can be made. Often these accounts are combined with other self-directed accounts, including traditional, Roth, SEP, and simple IRAs, health savings accounts, and individual 401k plans to make a single investment.

For example, I combined my daughter's Coverdell ESAs with our Roth IRAs to fund a hard money loan with two points up front and 12% interest per year." Hard money lending is an interesting real estate deal. We'll get into some other time. If any of you are experts in the hard money space, I'd love to do that in the form of an interview.

I've never worked in this space. I know some people who do hard money lending, but if any of you are experts, shoot me an email, joshua@radicalpersonalfinance.com, and let me know. Continuing with the story, "One client supercharged his daughter's Coverdell ESA by placing a burned down house under contract in the ESA.

The contract price was for $5,500, and the earnest money deposit was $100. Since the ESA was the buyer on the contract, the earnest money came from that account. After depositing the contract with the title company, the client located another investor who specialized in rehabbing burned out houses. The new investor agreed to pay $14,000 for the property.

At closing approximately one month later, the ESA received a check for $8,500 on its $100 investment. That is an astounding 8,400% return in only one month. How many people could have done that well in the stock market or with a mutual fund? But the story gets even better. Shortly after closing, the client took a tax-free distribution of $3,315 to pay for his 10-year-old daughter's private school tuition.

Later that same year, he took an additional $4,000 distribution. Assuming a marginal tax rate of 28%, this means that the client saved more than $2,048 in taxes. In effect, this is the same thing as achieving a 28% discount on his daughter's private school tuition, which he had to pay anyway." So that's a kind of a fun anecdote.

I assume it's true. I don't have any reason to doubt it, but a lot of times you read the sales copy on some of these people and I just question some of it. So that's a cool story. And it's a really useful, I think it's a really useful strategy.

For some of you who are investing experts and you are doing a lot of your own stuff self-directed, consider this because it really can be a useful scenario. And especially, yeah, it can be a useful scenario. I want to read you one other story here, which was kind of interesting in another one of these advertising ones for one of the custodians.

It's called "Solving High Educational Costs with Just One Deal." By the way, if you're not familiar with real estate, real estate investors love to tout these deals and they're awesome when they go. And I think experienced people do get them, but I would not get into the real estate business thinking that this is not the norm.

It's being reported because it's an amazing deal. So keep that with a grain of salt. It's doable. I've met investors, talked to them, who've done these deals, but it's still unusual. Doesn't invalidate the concept, but don't take this as, "Ah, this is what I'm going to do," unless you are already an expert or plan to become one.

Being familiar with real estate investing, the Smiths took full advantage of the Coverdell ESA's tax-free qualities. Their first year, they used $500 from their account to purchase an option on a real estate property, selling that option later in the year for $12,000, a profit of $11,500 tax-free, my note, as long as it's used for educational expenses.

At the end of the year, the $2,000 original contribution plus the $12,000 option sale, minus $500 in investments, had become a total of $13,500. In just one year, the Smiths had already stacked away enough money to put their child through college for one year. The Smiths gained control of their child's educational expenses with just one deal.

The second year, the Smiths continued to contribute the full $2,000 to their Coverdell Educational Savings Account. That year, they purchased another real estate option for $1,000, which they sold during the year for $11,000, making another $10,000 in tax-free profits. By the end of the second year, the Smiths contributed just $4,000, but their account was now worth $25,500, all tax-free if used for education.

After their success with their first two deals, the Smiths continued to do more real estate option deals, and once the account grew larger, they purchased and rehabbed a property. When their child turned 18 and was ready to attend college, the Smiths had saved more than $100,000 in their Coverdell Educational Savings Account.

With the average cost to attend a public college being around $13,000 a year, they saved more than enough to put their child through four years of a college education. It's not difficult to see how Joe and Sally Smith will continue in the future to gain control. Blah, blah, blah.

You get the point. Now, real estate option investing, is it work? Yeah, it works. Very specialized. I don't have a clue how to do it. I've never done it, but I've read enough real estate investors who've talked about it. If you are a real estate investor, I would encourage you, consider this.

Consider this as an option, because there are... As an option, no pun intended. You could do this, and especially if you found a deal that you were pretty confident in, and it was a small deal like these examples that they have done, it might be a fit for you, just for a few of you.

It might really be a good idea for you. Some of these guys will help you set it up with a checkbook where your LLC, you set up a self-directed IRA that owns your LLC, you become the controlling member of the LLC, and you basically have the checkbook of the company's LLC.

To the best of my knowledge, correct me if I'm wrong, I think this works. I think you could do some fun stuff with this. Real estate is the most significant, I think. That would be one of the areas I would focus on. If I were doing it, I would follow all of the rules for investments in a self-directed IRA, which is convenient, because sometimes some of these custodians seem to be setting it up for you so that, in essence, you can use your self-directed IRA, your self-directed HSA, and your self-directed ESA, and you can invest into deals with those because you've set up a common investment fund.

Perhaps they're doing it. I'm not exactly sure. I probably should reach out to somebody and talk to them, but I assume they're doing it in terms of splitting the member units of the LLC among those accounts. The accounts are holding the member unit of the LLC, and that's what I would guess is what they're setting up.

But in a self-directed IRA, there are certain things you're disqualified from investing in. You cannot invest in collectibles, so you can't buy artwork, you can't buy rugs, you can't buy antiques or metals or gems or stamps or coins or alcoholic beverages or other tangible personal property in an IRA.

You cannot do that in an IRA. There is an exception. Some of you are like gold and silver bugs, or what do you call yourselves? Gold bugs and silver stackers, right? I think that's the name that you use for yourselves. You can invest, your IRA can invest in one, one-half, one-quarter, one-tenth ounce US gold coins or one-ounce silver coins minted by the Treasury Department.

It can also invest in certain platinum coins and certain gold, silver, palladium, and platinum bullion. So I don't see any problem with some of you guys who want to invest in physical coins. I don't see any problem in doing that with your self-directed ESA. And just make sure that you're buying American eagles, either gold eagles or silver eagles, and American gold or silver eagles are explicitly permitted for self-directed IRAs.

That's an exception. So don't buy your numismatic francs or 1,700 gold sovereigns from wherever in this account, but just toss your new American gold and silver eagles and use that as part of your, put it into your allocation. Some of you guys are doing the, let's see, the permanent portfolio.

I would have no problem setting, set this up, have your LLC, rent the safety deposit box to put it in, or have your LLC buy a safe or do something like that and make sure that your LLC has the ownership of those assets. And if you feel that they're going to go up in value, great.

Now, many of you who were in that scenario, in that line of thinking are going to say, what's the point of the tax savings? I can walk down and sell the money and do a cash transaction, 2,000 bucks. You can easily do $2,000 transactions and it's totally off the books and you could sell it for kids' college and you're on the black market.

I can't argue with your logic. I just pointed out to you as far as being a scenario that I see the way that you, one option, because a lot of you are always looking for that and saying, how can I figure out how to do this? But I would look at it with real estate is what I would probably do.

Again, you could do some cool stuff with it. And this is where we'll get into self-directed IRAs at some point, but you could do some stuff. You could buy apartments and mobile homes and commercial real estate. You could do tax liens and notes and all kinds of stuff. So there's no reason why you can't set it up.

And again, remember, you can always start with the ESA and then put excess contributions into the 529. You cannot do self-directed stuff, to the best of my knowledge, in the 529 account. So that's not going to work for those of you who are doing that scenario. So last three things and we're done.

Let's talk about bankruptcy protection. Let's talk about college tuition, qualification, assets and financial aid process. And then we're going to talk about estate taxes and gift taxes. And then we're done. But these are important aspects to it. And hopefully you're starting to see, if you're listening to the show and you're two hours in, hopefully you're starting to see why I started the show and why I'm two hours into an episode and I've still got three other things to cover.

This is the value of a good financial planner. This is why rich people hire good financial planners. And you may have a situation that's simple enough you don't need to. In that case, great. Use this knowledge and do something else. But a good financial planner can save you a lot of money with all of this stuff.

Bankruptcy. U.S. bankruptcy laws changed significantly in 2005. And those laws, what most of you would have read about, was the changes in basically how easy or difficult it was for people to file bankruptcy with credit card debt or based upon credit card debt. But there was something important in that law.

It was the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005. There was an important change for people who were saving for college. And it was additional protection or rather clarifying of protection for 529 plans and Coverdell educational savings accounts. And so this is important. You always want to be thinking about bankruptcy protection.

Just because you don't borrow money doesn't mean you can't be forced into bankruptcy. And the problem with bankruptcy planning and bankruptcy protection is you have to have it in place long before you're ever in a situation where you're pressured. If you talk to any bankruptcy attorney, I just think constantly, "How can I protect from bankruptcy?

Protect from bankruptcy? Protect from bankruptcy?" You don't want to be wiped out. So think about bankruptcy from the beginning when things are going well. Because the bankruptcy law is consistent. You cannot do things last minute to shelter yourself from bankruptcy. But you can do things up front that are smart and intelligent so that if for some reason you are forced into bankruptcy, and maybe there can be many reasons, whether it's you had a negative legal event where your daughter or son kills somebody and you get sued, somebody slips and falls, and for whatever reason you get a judgment against you, maybe it's a medical malpractice judgment, maybe it's some kind of issue where you're forced into bankruptcy even if you're not doing risky investing.

If you are doing risky investing, and risky investing is called starting a business, plan for bankruptcy 10 years before you ever start the business and take care of yourself. That is prudent planning. Know the laws and take advantage of them. One of them that you can take advantage of is the creditor protection and the bankruptcy protection in 529 accounts and educational savings accounts.

This was strengthened in that law that was passed in 2005. It was finally clear federal legislation protecting these college accounts in the same way that there's clear federal legislation protecting 401k accounts and pension accounts. There's clear federal legislation protecting college accounts. Coverdell educational savings accounts are covered. There are some details that you need to be aware of.

Basically what you want to do is you got to fund these things long before you ever get into bankruptcy. What they set up as a scenario, as far as the rules, is that if you get too close to the bankruptcy date, there's limited protection. If you set up an ESA for your kids and you put $2,000 in every year for the first 10 years of their life, and then when your oldest child is 15 years old, you go into bankruptcy, all of the contributions prior to that time are going to be protected.

If you did contributions within, what is it, 720 days, I think it was 720 days, two years basically. If you made a contribution in the last two years, only about $5,000 is protected from bankruptcy law. Anything older than two years is fully protected in case of bankruptcy. Anything in the last two years, what is it, is either not protected or it's protected only to the tune of $2,000.

So sorry, any funds contributed in the last 365 days, those are available to the bankruptcy court. Now there are some gotchas, and you got to make sure that you take care of this with your bankruptcy attorney. Make sure if you're ever going through bankruptcy, work with a good bankruptcy attorney because the funds that are in an ESA, in an educational savings account, are excluded from the bankruptcy estate as long as the debtor files a notice into the record of the bankruptcy case of his interest in the account.

So you need to tell the bankruptcy court about it. If you don't do some of these things, if you don't do that, then it might be included in the bankruptcy estate, which is available for your creditors. If you file the notice, as I understand it, I'm not an attorney or a bankruptcy specialist, as I understand it though, as long as you file the notice, then that is fine.

The other exceptions that might result in the funds being included in the bankruptcy estate, which is available to your creditors, is if the child was not a child, including stepchildren and grandchildren, was not a child of the debtor during the tax year that the funds were deposited into the ESA.

So that could occur if a child was adopted after the money was put into the educational savings account, so you'd be careful there. If the funds are excess contributions, then those are also going to be available to the creditors, so you want to be careful there. It's just worth being careful of.

So useful from the perspective of if you're doing asset protection planning, aka bankruptcy planning for a client, this can be a useful account for you. Next is financial aid, and this is a very, very detailed scenario of financial planning, because 529 accounts and educational savings accounts do affect your child's eligibility for financial aid.

And this is, as far as my observation, one of the most uncertain, constantly changing scenarios of financial planning that I'm aware of. And so I would definitely be working with a specialist if I were doing extensive planning in this area. But in essence, a couple of rules. It's probably better to keep the money in a 529 account.

It is a couple of general rules as I understand them here in November 2014. If any of you specialists catch something I say wrong, come by and correct me at radicalpersonalfinance.com/coverdell. It's always better to put the money in a 529 account or an ESA rather than just to give it to the child or put it in a custodial account.

So that is one useful thing. From the regard of financial aid, usually what we're talking about here is figuring out the FAFSA, which is the Federal Free Application for Federal Student Aid form. If you read through the FAFSA, you'll see that it requests different bits of information. And so you got to be careful there.

But if money is in a college account, it's probably going to be better off to be in a college account than it is to be in just an account that the child has control over. If you study the FAFSA, I think you find some planning opportunities if you have grandparents or other people.

So for example, if a grandparent opens an educational savings account for their child or a 529 with the child as a beneficiary, it may not be reflected on the FAFSA. Some schools do use a different form called the CSS profile, and that form does reflect balances for any other plan where the student is simply a named beneficiary, not just as an owner of the account.

An educational savings account, a Coverdell account, is treated as an asset of the account owner. If the account owner is the student, then that is going to impact their financial aid eligibility. But that changed a little bit, however, based upon whether the student is a dependent student or not.

So the law that would be referenced by the specialists in this area, the Higher Education Reconciliation Act of 2005, added a special treatment for Coverdell accounts, prepaid tuition, and 529 college savings plans that are owned by a dependent student. And the impact on need-based aid for dependent students will be minimal.

If the account owner is the parent, this has a low impact, the ESA has a low impact on financial aid eligibility. Qualified distributions from a Coverdell account are not counted as income on the FAFSA, and thus do not reduce financial aid eligibility. So you got to be careful here as far as what the rates are.

And in general, there are usually benefits to having the money in the parent's name. When you start looking at the details of the Coverdell, you want to take a look and see which person is the account owner. If the child is the account owner, then it's a child asset.

If the parent is the account owner, then it's a parent asset. So in many cases, the child is listed as the account owner, but be careful with your paperwork as far as how you set this up. If the ESA is owned by a student and the student is both the account owner and the beneficiary, then it's too complicated for me to get into.

Spend some time with a specialist if you're going in this area. I don't want to go any deeper into this simply because I think it just gets too confusing. In general, I think it's better to have the parent as the owner and the child as a beneficiary. Oftentimes, if you're doing this kind of planning, then the whole federal student aid thing is so impossible for me to predict simply because the law is going to change.

It changes all the time. Again, you get into the deal of it's impossible to predict, at least in my opinion. So you've got to look at your account paperwork and work with your advisor and read through this. Do some looking online and read through this because you've got some Coverdell paperwork is going to have the designated beneficiary and a responsible person.

Some are going to have a depositor and you want to make sure that you get that correct. Then, depending on if you're dealing with the income limits or not, that's going to affect your situation. It really doesn't matter in many ways because depending on how much money you have in the account, how much money you're actually planning for, a lot of times these are fairly clear.

The person's not eligible for financial aid or it's minimally eligible or we get into the world where it's a little bit specialized. I'd encourage you, there's a whole team of financial planning. I don't even remember the name of the organization right now that specializes in education planning. I'd encourage you to consider talking to them or to your own planner.

Last thing here is estate taxes. With this, we're going to close. But estate taxes, you need to be aware of it, especially this is going to be more applicable to many of you who are financial planners as far as how to use this in your estate tax planning. There's a really great, I'm just going to read a one and a half page guide here from Kay Thomas who's writing at fairmark.com.

I thought about going through and doing this, but she does the best summary. I can't improve it, so I'm going to read it and link to this in the show notes. But it's very clear and it's very useful. If you're not familiar with estate taxes, just listen and try to absorb the language.

But for you planners, this will be useful. So the special rules that apply to a Coverdell account for estate and gift taxes are favorable in some ways and unfavorable in other ways. Contributions. A contribution to a Coverdell account is treated as a completed gift of a present interest. That's tax speak 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 amounts.

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.

So in this scenario, when you're looking at the gift tax, it is a completed gift of a present interest. So therefore, it is outside of the estate, which it means it's qualified as a gift, but you can't additionally make the gifts. It's not a tuition prepayment. So you could have the donor make the payment directly to the university, and in that situation, it would be excluded from being a gift as long as it's directly to the university.

This doesn't qualify for that. So just be aware of that difference. This would be counted as part of your annual gift tax exclusion calculations. Withdrawals. Given that you're making a gift when you put money into a Coverdell account, you would expect to find out 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. Change in beneficiary. 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 the purposes of this rule, but the basic idea is as follows. Treat the beneficiary's spouse as being in the same generation as the beneficiary, no matter what the difference in age is.

For all others, determine the generation by counting the number of generations from the grandparent of the beneficiary to that person. So you need to be careful with this when you get to generation skipping transfer tax and just follow the careful rules. Just research it, but that's the general gist of it.

Example, you set up a Coverdell account for your son, but you never use 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. So, a wordy example, but it does matter, especially when you're talking about what I was talking before about how you could set this up for multiple generations.

Pay careful attention to this. A gift greater than 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 that 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. And then estate tax.

Normally, if you retain the kind of powers you 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. Hope I didn't lose all of you people who are not financial planners at the end, but I did want to make, in order to create a complete resource here, which is what I'm trying to do, I did want to make sure that I mentioned the estate tax rules.

It really is an interesting account. It really is. And the Coverdell account is often pooh-poohed by people simply in the same way that it was pooh-poohed by that Forbes writer. It's just said, "Ah, this is a ridiculous account." That's always what I thought until I started researching it. Because again, they must know what they're talking about.

And then I started researching it and I found, "Wait a second. None of those things apply. I could figure out a way to use it." Many people get into this comparison of top 529 account versus educational savings account. And that is right. As far as the comparison, if I had to make a judgment call, I would say that in many ways the ESA is going to be more flexible.

And depending on how much you're saving, I would discourage... So let me pause. I would first say, don't save for college. Save for retirement first. And when you are way on track for retirement, then save for college. That's going to cut out most of you. Number two, I would say, why would you save so much money for college that when there's so many cheap options, and why would you want all the money stuffed aside in the college account?

That would get rid of a lot more of you. And it's a lot easier to go to college for cheaper than save all this money. Now, for those of you to whom college is a big deal, and you have a lot of money, and we're doing very fancy planning, then I would look at these accounts.

I wouldn't suggest college accounts for the average rank and file, median income, $45,000 a year family. Just why bother? It's too much hassle for too little reward when you're putting aside $100 a month. But if we're getting into very fun, sophisticated planning, then go ahead and get into this.

And I think the Coverdell has some advantages, has some disadvantages as well. But that's actually how I'd answer the question. If I had to go between them, I'd probably start with the Coverdell account. I like the investment flexibility. The $2,000 number, though, makes it really tough to get money in.

So usually, we're just automatically going to be doing this and a qualified tuition plan, a 529 savings plan, because we can frontload it so much. And we'll deal with that in another show on another day. So to wrap up these four things, let's see if I got them right.

First, the problem that I started the show with, the Coverdell contributions are limited to $2,000 a year. 529s are pretty close to unlimited. He's right. But that's less of a story, especially knowing that there are some exceptions to that. For example, the SGLI, the Service Members Group Life Insurance, money can go into that.

And also, the contributions are limited. But once you build them up over time with multiple beneficiaries, you can start to get some serious money into this if you do. And then the beneficiary can be transferred. So you could create a process to get money into them. The right to contribute to a Coverdell is phased out as the parent's income passes $190,000 and the 529 has no income rules.

That's exactly right, except that that's the easiest rule to circumvent that was ever written into tax legislation. Number three, there's a good chance you'll get a state tax deduction on the 529 contribution. I admit it to him here. He's right. It's that the 529, you can deal with your state tax deductions.

However, and you don't get that with the Coverdell, but consider the investment opportunities. And the Coverdells have time limits. They have to be started before the beneficiary turns 18 and used up by age 30. That's true. But when you can make a qualified distribution at the age of 30, right into a 529, what's the difference?

What's the difference? Same old, same old. I hope you enjoyed my epic. I know it was a lot and feel free to listen to this a couple of times. If this show didn't appeal to you, if you didn't understand the language, I hope you still listen to it because sometimes that's okay.

I know when I first got into financial planning, I didn't, I was like, what's an annual exclusion amount? What's a crummy notice? All these words. And you start to hear them and all of a sudden you'll start to hear them in context and they will make a difference for you.

But that's my information on Coverdell educational savings accounts. Hopefully it's useful for you. I've never seen anything like this brought together, especially not an audio form. You read articles and usually they're a page or two, but none of them are very complete. So I think that by listening to this, you have a complete resource and I've created it so that I can send people with questions to this.

This information has been helpful for you. I would love it if you consider joining the membership program that I've created, the irregulars. That's how I pay the bills here at the moment is entirely listener support. So if I helped you save some money, again, this was as a financial advisor, I could never do this because how could I spend two and a half hours answering someone's question on this, but I could do it in a podcast.

So I would be thrilled if more of you would consider joining the membership program, totally voluntary. If you can't do it, no big deal. I understand. I mean it. If you found some mistakes, anything I said today, I need to know about it. I've done the best I can, but even as the disclaimer, which I'll play in just a moment says I'm one guy sitting down trying to create useful instructional media for you.

So check out, let me know if you're going to act on this information, come by the show page at radicalpersonalfinance.com/coverdell and take a look at it and see if anybody's commented and corrected anything in any of the information today. I think that's it. Tomorrow, I'm going to push David Downey's interview off.

I may release it tomorrow for you or I may do a Q&A show. I'll decide that in the morning. I'm tired. Thank you for listening to today's show. This show is intended to provide entertainment, education, and financial enlightenment. Your situation is unique and I cannot deliver any actionable advice without knowing anything about you.

This show is not and is not intended to be any form of financial advice. Please, develop a team of professional advisors who you find to be caring, competent, and trustworthy, and consult them because they are the ones who can understand your specific needs, your specific goals, and provide specific answers to your questions.

Hold them accountable for your results. I've done my absolute best to be clear and accurate in today's show, but I'm one person and I make mistakes. If you spot a mistake in something I've said, please come by the show page and comment so we can all learn together. Until tomorrow, thanks for being here.