Tax planning and compliance for investors
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Income tax, and possibly a penalty, will apply to earnings that are withdrawn in a year when there are not enough qualified expenditures.
When the amount you withdraw from your Coverdell account is greater than the qualified education expenses for the year, the beneficiary (student) has to pay tax on the earnings portion of the excess. Unless an exception applies, the student also has to pay a 10% penalty tax for making a nonqualifying use of money from a Coverdell account.
You don't have to report the entire distribution as taxable income. Only the earnings portion is taxable. This is determined the same way as for a traditional IRA for which you've made nondeductible contributions. Here's the basic idea:
Example: Suppose your contributions to a Coverdell account over the years added up to $3,000. During 2005 you took out $1,500, but had only $1,000 of qualified education expenses. At the end of 2005 the account value was $3,500. That means there would have been $5,000 in the account if you hadn't taken any money out, consisting of $3,000 in contributions and $2,000 of earnings. The earnings percentage is 40% ($2,000 divided by $5,000). The amount of income is $200 (40% times $500, the part of the withdrawal that wasn't used for qualified education expenses).
Notice that the earnings amount is based on the value of the Coverdell account. Unlike a regular investment account, these accounts can be treated as having earnings even if they never received any income or sold anything for a profit. If the value of the account has gone up (for example, because the account is invested in stocks that climbed in value), it's treated as having earnings. By the same token, an account can have zero earnings even after it has received interest and dividends, if it also has investments that have declined in value.
When an account has zero earnings, there's no tax (or penalty) on a withdrawal, even if the money is used for something other than education.
If account earnings end up being taxable, they're taxed as ordinary income. You don't get the benefit of long-term capital gains rates even if the earnings came from long-term investments in the Coverdell account.
The tax law says the income is taxable to the "distributee." In Publication 970, the IRS says the beneficiary pays the tax, based on the apparent assumption that the withdrawal goes to the beneficiary, or is used for the benefit of the beneficiary.
Subject to exceptions explained below, a 10% "addition to tax" — in other words, a penalty — applies when you report taxable earnings from a Coverdell account. The idea here is to discourage people from using a Coverdell account as a way to postpone paying tax on investment earnings if the money isn't going to be used for education. Congress provided the following perfectly logical exceptions to this penalty:
There is also a special exception for students attending a U.S. military academy.
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