1. Coverdell Education Savings Account: Introduction
  2. Coverdell Education Savings Account: Who’s Eligible to Contribute?
  3. Coverdell Education Savings Account: Opening an ESA
  4. Coverdell Education Savings Account: Avoiding Taxes on Distributions
  5. Coverdell Education Savings Account vs. 529 Plan
  6. Coverdell Education Savings Account: Conclusion

A Coverdell ESA is meant to be used for qualified education expenses. Failing to stick to the IRS guidelines for distributions could trigger a tax penalty. Here are some scenarios that could result in a tax bite.

Withdrawals for Expenses Other Than Education

The IRS is very clear about what an ESA can be used for. Qualified education expenses for higher education include:

  • tuition and fees
  • books, supplies and equipment
  • expenses for special-needs services required by a special-needs beneficiary
  • room and board for students who are enrolled at least half-time
  • computer equipment, software, internet access or related services if used primarily by the beneficiary while they’re enrolled

Qualified expenses for elementary and secondary education include:

  • tuition and fees
  • books, supplies and equipment
  • academic tutoring
  • special-needs services for a special needs beneficiary
  • room and board if attending a boarding school
  • uniforms
  • transportation
  • supplementary items and services, including extended day programs
  • computer technology, equipment and internet access

All qualified expenses must be paid to an eligible school. That includes colleges and universities that are eligible to participate in federal financial aid programs, and elementary and high schools that meet state standards. If funds in a Coverdell ESA are used for anything that doesn’t fit into either of these categories, a 10% tax penalty applies and any earnings on the distribution are subject to regular income tax.

The IRS does allow for some exceptions allowing you to avoid the 10% penalty on taxable distributions. The penalty can be avoided if:

  • Distributions are made to a beneficiary or the estate of the designated beneficiary on or after the death of the designated beneficiary
  • Distributions are made because the designated beneficiary becomes disabled
  • The designated beneficiary is attending a U.S. military academy
  • Distributions are included in income because the beneficiary received a tax-free scholarship or fellowship grant, veterans’ educational assistance, employer-provided educational assistance, or any other tax-free payments (excluding gifts or inheritances) to pay for education expenses
  • Distributions are included in income because the qualified education expenses were considered in determining the American Opportunity or Lifetime Learning Credit

Tax Penalties for Distributions Beyond Age 30

The money you contribute to a Coverdell ESA can’t remain there indefinitely. Once the beneficiary reaches age 30, any leftover funds must be distributed within 30 days. After this point, the distribution earnings would become fully taxable and the 10% penalty would apply. You can, however, avoid the penalty by rolling the balance over to another Coverdell ESA for a different beneficiary.

So just how high could the penalty climb? Let's say Julie accumulates $2,000 in deposits per year until her 18th birthday. She has $36,000 of pre-profit or interest earnings. She earned $18,000 from this investment and has $52,000 in the bank at age 18.

Julie wins a full-ride scholarship and ends up using the money in her ESA for textbooks only. She uses a total of $2,000 of her contributions and her investments earn another $30,000 by the time she turns 30. With $48,000 in earnings and $34,000 in contributions, she’d be taxed on the earnings and 10% early distribution penalty as well which would amount to $4,800. While this seems like a lot of money, she still has $77,200, less any income tax owed on the earnings. She could transfer her ESA to a beneficiary, a younger sibling or spouse, to avoid taxes. However, she would no longer have the money.

Coverdell ESA Rollovers That Avoid Penalties

If you don’t think all the money in a Coverdell account will be used up and you want to avoid the penalty, you can roll those funds over to someone else. Rollovers must be completed within 60 days after the funds are distributed; otherwise, the entire amount is subject to taxes and penalties.

The rollover must be to another person who qualifies as an eligible beneficiary under age 18 who is a family member. That includes:

  • a child, stepchild, foster child, adopted child or any of their descendants
  • a sibling or stepsibling
  • a parent or stepparent
  • a spouse or in-law
  • a first cousin

You can only make one rollover from a Coverdell ESA to another Coverdell account in any 12-month period. But, you can make unlimited transfers from ESA trustee directly to another ESA trustee, since these aren’t considered distributions or rollovers. If you’re rolling over to a new account, remember to follow the same rules for comparing accounts as you did when initially opening your Coverdell ESA. If the beneficiary is over 18, he or she will need to sign off on the rollover paperwork consenting to the move. 

Coverdell Education Savings Account vs. 529 Plan
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