Here’s what happens when a Coverdell education savings account has earnings or losses.
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.
However, it may be possible to claim a loss by liquidating a Coverdell account. In Publication 970, the IRS says this:
If you have a loss on your investment in a Coverdell ESA, you may be able to take the loss on your income tax return. You can take the loss only when all amounts from that account have been distributed and the total distributions are less than your unrecovered basis.
The big unanswered question here is this: in the quotation above, who gets to claim the loss? The IRS says “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 seems like they must be talking about the beneficiary, because in all other respects they are treating the beneficiary as the taxpayer for the account. Usually that means the loss will be claimed by a minor, or by a young adult without enough income to secure any real benefit from the deduction. The bottom line here is that you shouldn’t expect to obtain a tax benefit from losses that occur within a Coverdell account.
If you have a loss and want to try to recover a tax benefit, see the discussion in IRS Publication 970.