Tax planning and compliance for investors
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By Kaye A. Thomas
Updated May 28, 2007
How to take money from a Coverdell education savings account without paying tax on the earnings.
If all goes as planned, the investment earnings of a Coverdell account can be entirely tax-free. To achieve that happy result, you need to have qualified education expenses at least equal to the amount of the distribution. The rules here are fairly generous, but not infinitely generous. Here's what you need to know.
You don't have to use the money from the Coverdell account to pay the expenses. You simply need to have the expenses in the same year you take the withdrawal.
Example: In February you take $5,000 from a Coverdell account and use the money to buy an auto for the beneficiary — not a qualified education expense. In September you take out a loan to pay $5,000 in tuition for the beneficiary of the Coverdell account. The February withdrawal is tax-free because the expenses fell in the same year.
As explained later, expenses that count for this purpose can be reduced by amounts received as scholarships and other assistance.
Here are the qualifying education expenses that will permit you to take tax-free withdrawals from a Coverdell account:
When adding up qualified education expenses for the year, you have to subtract any expenses that were covered by tax-free scholarships and similar assistance. You don't have to subtract a gift or inheritance, however.
Example: Your child's school costs for the year were $8,000, with $1,500 covered by a scholarship and $2,000 paid using a gift from a grandparent. You can count $6,500 as qualified education expenses.
You also have to reduce the amount that is qualified for the Coverdell account by amounts you use to qualify for other tax benefits, as explained here.
You might take money from a Coverdell account expecting it to be tax-free, only to find that qualified expenses are less than expected (or the reduction for scholarships is more than expected). If you act before the end of the year, you can avoid paying tax on the Coverdell account distribution by contributing an equal amount to a 529 plan for the same beneficiary. That's because a contribution to a 529 plan is treated as a qualified education expense for purposes of the Coverdell account rules. Normally you would use this rule when you intended to move the money from a Coverdell account to a 529 plan, but you can also use it to avoid tax when qualified expenses turn out to be less than expected.
Example: You took $6,000 from the Coverdell account early in the year, expecting to pay a tuition bill in that amount later in the year. Then your child decided to take a semester off, so you don't have a qualified expenditure to match the withdrawal. The money has been out of the Coverdell account too long for a rollover. As a result, the portion of this withdrawal representing earnings will be subject to tax and penalty if you do nothing. You can avoid that result by contributing $6,000 to a 529 plan for the same beneficiary by the end of the year.
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