Within limits, you can use a Coverdell education savings account together with other tax breaks for education.
The original version of the Coverdell education savings account (called the “education IRA”) imposed strict limits that made it hard to claim other tax benefits at the same time. The 2001 tax law made it much easier to use Coverdell accounts together with other tax breaks. The general rule beginning in 2002 is that you can’t use two tax breaks for the same dollars, but you can use different tax breaks for different dollars in the same year. For example, if tuition is $5,000, you can use one tax break for $2,000 of that amount and a different tax break for the other $3,000.
Hope and Lifetime Learning Credits
Originally, you couldn’t claim the exclusion for earnings withdrawn from a Coverdell account in the same year you claimed an education credit — the Hope credit or the lifetime learning credit. Beginning in 2002 you can claim these credits in the same year you claim the Coverdell account exclusion, but you can’t claim them for the same expenses.
Example: Suppose you had $6,500 of qualified education expenses. If you use $2,000 of those expenses to claim the Hope credit for this student, you can treat only $4,500 as qualified education expenses that allow you to take tax-free withdrawals from a Coverdell account.
What if you need to withdraw the full $6,500 from a Coverdell account to cover the expenses? In that case you have a choice. You can take the entire withdrawal tax-free, in which case you won’t be able to claim the credit. You’re also allowed to treat $2,000 of the withdrawal as a nonqualifying expense so you can claim the credit. The student will pay tax on the income portion of that $2,000, but that’s likely to be a lot better than giving up the Hope credit.
Example: As of the year you are taking withdrawals from the account, 75% of the account balance represents money you contributed and the rest is investment earnings. If you choose to treat $2,000 of the Coverdell account withdrawal as a taxable distribution, you can qualify for a Hope credit that will reduce your taxes by $1,500. The beneficiary will have to report $500 of income (25% of $2,000). The tax cost will depend on the beneficiary’s income level, but will probably be $75 dollars or less.
There’s no penalty on a withdrawal that’s taxable only because you chose to make it taxable to qualify for another benefit.
529 Plans
Beginning in 2002 you’re permitted to contribute to a 529 plan in the same year you contribute to a Coverdell account. You’re also permitted to withdraw from both in the same year. If the total amount withdrawn exceeds your qualified education expenses for the year, it’s your choice how the excess is allocated. It doesn’t matter where you took the money out first.
Example: Your qualified education expenses are $8,000 and you took $5,000 each from a Coverdell account and a 529 plan for a total of $10,000. You don’t have to report a $1,000 excess from each, or a $2,000 excess from the account where you took the second distribution. You’re allowed to figure out which way you get the better tax result. For example, if you have more earnings in the Coverdell account than the 529 account, it’s probably better to treat the $2,000 excess as if it came from the 529 account.
The IRS says you can use “any reasonable method” to allocate the excess between the Coverdell account and the 529 plan.