Coverdell Education Savings Accounts: Taking Distributions

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The point of having a Coverdell ESA is to enable you to pay for some or all of your student's qualified educational expenses with a combination of money you've saved (on which you previously paid income tax) and the earnings on your savings, on which you've paid no tax.

What you may not realize is that you are not actually the one making the payments for these expenses; your student is when using distributions from a Coverdell ESA. When distributions are made from a Coverdell account, the IRS considers them made to the student (even if checks are written directly to an educational institution), and the student bears the financial consequences.

If distributions are made for qualified expenses before December 31, 2010 (and if Congress takes no action on extending or making the current provisions permanent), your student won't pay any tax. If a distribution is made for a nonqualified expense (for example, he used money to buy a computer for college, even though it wasn't a requirement of his course), then tax needs to be paid on the income portion only. A 10 percent penalty will probably also be applied, for good measure.

The amount of qualified educational expenses are always reduced when your student receives any tax-free form of educational assistance, including, but not limited to, tax-free scholarships, veterans' educational assistance, Pell Grants, and employer tuition reimbursement programs. Be aware of these other payments to or on behalf of your student when calculating how big a distribution to take from a Coverdell account; if you're too generous, your student will pay the price.

If your student takes a taxable distribution from a Coverdell account, the 10 percent penalty will be waived under the following circumstances:

• A taxable distribution is made on account of the death of the designated beneficiary, either to the beneficiary or to his or her estate.

• A taxable distribution is made when it's used for nonqualified expenses, but the expenses are incurred due to the disability of the designated beneficiary. You must attach a doctor's statement to your beneficiary's tax return, indicating the type of disability and the expected duration or whether it's expected to result in death.

• A taxable distribution is made in excess of qualified educational expenses because those expenses were reduced by the receipt of nontaxable educational assistance. For example, Joan has qualified educational expenses of $10,000, takes a $10,000 distribution from her Coverdell account to pay for those expenses, and then finds that she also is receiving a tax-free scholarship for $5,000 from her school. In this case, only $5,000 of the Coverdell distribution is being used to pay for qualified educational expenses. Because Joan's qualifying expenses were reduced by the $5,000 scholarship, the income portion of the remaining $5,000 Coverdell distribution is subject only to income tax, and not an additional 10 percent penalty.

• A taxable distribution occurs only because qualified educational expenses were used to enable the taxpayer to take the Hope or Lifetime Learning Credit.

• A taxable distribution occurs because excess contributions given in the current tax year are returned to the designated beneficiary before he files his tax return for that year.