How Do You Take Money Out of Coverdell ESA Without Paying Taxes?
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If you have been saving for a child’s education through a Coverdell Education Savings Account (“ESA”), it is essential to know how to take the money out correctly. Done right, withdrawals can be completely tax-free. However, you may face taxes and penalties, reducing the account’s value, if you do not withdraw the money properly.
Coverdell ESAs are special tax-advantaged accounts that help families save for education. Earnings and withdrawals are free from federal income tax if the funds are used for qualified education expenses.
Understanding Qualified Education Expenses
The IRS allows you to use Coverdell ESA funds for various education costs, not just college tuition. This is where Coverdell accounts stand out from the 529 plans, which have more limited uses for K-12 education.
For higher education, qualified expenses include tuition, fees, books, supplies and equipment required for enrollment. Room and board also come under it if the student has been enrolled at least half-time, but only up to the school’s published cost of attendance.
For elementary and secondary schools, the list is broader. You can use ESA funds to pay for tuition, books, tutoring, uniforms, transportation, room and board, and even computer equipment and internet access, as long as they are used during school years.
How Withdrawals Work
Withdrawals, also called distributions, are tax-free as long as the amount you take out does not exceed the beneficiary’s qualified education expenses for that year. The distribution can be made directly to the school, to the beneficiary or to the person who paid the expenses.
If the amount you withdraw is more than the qualified expenses, the extra is considered taxable income to the beneficiary. On top of regular income tax, the IRS imposes a 10% penalty on the earnings portion of the non-qualified withdrawal.
Coordinating With Other Education Benefits
One mistake made by most families is double-dipping, using ESA funds and claiming an education tax credit for the same expenses. You can use both in the same year, but they must cover different expenses. For example, you may claim a credit for tuition and use ESA funds for books and supplies.
What If the Child Does Not Use the Funds?
If the beneficiary finishes school with money left over or never uses the funds, you have a few options. The remaining balance can be transferred to an appropriate family member under age 30, such as a sibling, cousin or even yourself if you go back to school. This transfer can be done tax-free.
If no eligible beneficiary is available and the child reaches age 30, you must withdraw the funds. In that case, earnings will be taxable and subject to the 10% penalty unless the child is a special-needs beneficiary, in which case the age limit does not apply.
Timing Your Withdrawals
The IRS expects withdrawals to match expenses in the same tax year. If you pay tuition in December but wait until January to withdraw funds, that distribution will count for the following year, which may make it taxable if there are no qualified expenses left to offset it.
Bottom Line
Taking money out of a Coverdell ESA is straightforward if you stick to the rules. By understanding the basics, you can maximize the tax advantages of your ESA and stretch your education dollars further, whether your child is in kindergarten, high school or pursuing a graduate degree.