The whole point of a Coverdell ESA is to save money for education expenses — both for college and K-12 — and cash it in tax-free. When the beneficiary of a Coverdell ESA (the student) withdraws money from the savings account, that's called a distribution. Distributions are tax-free if they meet both of the following criteria [source: IRS]:
- The money must be used to pay for qualified educational expenses.
- The total of all distributions cannot exceed the total amount of educational expenses incurred in the tax year.
So what, exactly, is a qualified educational expense? The IRS breaks these down into two categories: Qualified Higher Education Expenses and Qualified Elementary and Secondary Education Expenses.
For the higher education expenses, the beneficiary of the Coverdell ESA must be enrolled in an eligible school at least half-time. Expenses that qualify for tax-free distributions include tuition, fees, books, supplies, equipment, room and board, and expenses related to special needs services [source: IRS].
The list of tax-free elementary and secondary education expenses is a little longer and includes tuition, fees, books, supplies, equipment, room and board, special needs services, academic tutoring, transportation, uniforms, and even computer equipment and Internet access, as long as its used for academic purposes [source: IRS].
Remember that one of the criteria for tax-free Coverdell distributions is that they can't be greater than the total amount of educational expenses. There's a catch, though. If you receive any other form of financial assistance, you need to subtract those amounts from your educational expenses first. So if a year of college costs $30,000, but you receive $20,000 in tax-free scholarships, Pell grants, veteran's grants or employer-provided educational assistance, then your total educational expenses for the year are reduced to $10,000.
You are allowed to also claim the American opportunity or lifetime learning tax credit in the same year that you take the Coverdell ESA, as long as the same expenses are not used for both benefits.
If a Coverdell ESA beneficiary withdraws too much money from the account, the excess distribution is taxable. Check out the complete formula for calculating the tax liability — warning: it involves fractions — in the Taxable Distributions section of IRS Publication 970, Tax Benefits for Education.
If you take a distribution from a Coverdell ESA, you will receive a second information return called an IRS Form 1099-Q. The form will show much money you withdrew from your account during the tax year. Use this amount to compare with your educational expenses when figuring what is taxable and — fingers crossed — what isn't.
Author's Note: Coverdell ESA Form Explained
As a parent of three young children, I spend considerable time worrying about how we're going to pay for their college education. I'm grateful that there are savings accounts available — Coverdell ESAs and state-run 529 plans — that allow my wife and I (and our generous parents) to set aside some money that will grow tax-free and be earmarked exclusively for education expenses. I also try to comfort myself with the fact that no one pays full tuition at any college or university, and that financial aid packages are designed to make up the difference between the full bill and what a family can afford to pay.
But I'm also disappointed that my kids will likely enter the "real" world saddled with student loan debt. Who knows, though, but the time my first kid enters college — a decade away, still — the whole system might be replaced by free MOOCS. A poor dad can dream, can't he?
- IRS. "Coverdell Education Savings Accounts (ESA)." Publication 970, Tax Benefits for Education. 2013 (Dec. 12, 2014) http://www.irs.gov/publications/p970/ch07.html
- IRS. "General Instructions for Certain Information Returns" (Dec. 12, 2014) http://www.irs.gov/instructions/i1099gi/ar02.html#d0e1316
- IRS. "Instructions for Form 5498-ESA" (Dec. 12, 2014) http://www.irs.gov/instructions/i5498e/ar02.html
- IRS. "Topic 310: Coverdell Education Savings Accounts" (Dec. 12, 2014) http://www.irs.gov/taxtopics/tc310.html
- National Center for Education Statistics. "Fast Facts: Tuition costs of colleges and universities." 2013 (Dec. 12, 2014) http://nces.ed.gov/fastfacts/display.asp?id=76
- Saving for College. "Compare Savings Options" (Dec. 12, 2014) http://www.savingforcollege.com/compare_savings_options/?assigned_to%5B%5D=0&assigned_to%5B%5D=1&hiddenField=vehicles&mode=Submit