Here’s what happens when a Coverdell education savings account has earnings or losses.
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Unless you invest in something exotic enough to generate unrelated business taxable income, no tax applies to income or gains within your Coverdell account. This is one of the two great tax benefits of Coverdell accounts. Earnings can grow tax-free, allowing compounding at a higher rate. If the earnings stay in the account for an extended period of time, the benefit can be substantial.
Character of Income
Income tax may or may not apply when you take the money out, depending on whether the beneficiary has enough qualifying expenditure in the year of the distribution. If the earnings become taxable, they will be treated as ordinary income, even if they arose from stock investments that would otherwise have produced long-term capital gains. Within a Coverdell account, it doesn’t matter whether earnings come from interest, dividends or capital gains. All forms of earnings are treated the same.
It’s important to remember that investments can produce losses as well as income. Just as the income of a Coverdell account is not taxable, any losses you have in a Coverdell account are not deductible. If your Coverdell account loses value, you may feel it’s unfair that you can’t claim a deduction, but this is simply the other side of the coin that permits you to avoid paying tax on the income.
Before 2018, it was possible to claim a loss by liquidating a Coverdell account if total distributions, including liquidating distributions, were less than the total amount contributed. This deduction was eliminated for years after 2017 and before 2026. Its revival in 2026 is far from certain, as Congress may decide to make its elimination permanent.
If the deduction is reinstated, there is some question as to who gets to claim it. The IRS has said “you” may be able to claim the loss, but doesn’t make it clear whether they are talking to the person who created the account or the beneficiary. It appears they must be talking about the beneficiary, however, because in all other respects they are treating the beneficiary as the taxpayer for the account.
The beneficiary may not have enough income to secure a benefit from the deduction if the account is closed when the beneficiary completes his or her education. Delaying liquidation of the account until the beneficiary has more income may make sense. However, the account must be liquidated no later than 30 days after the beneficiary reaches age 30.