Using Coverdell Accounts with
Other Tax
Breaks
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earnings withdrawn from a Coverdell account in the same year you claimed an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. |
Coverdell top page |
Next: Taxable Withdrawals and Penalty Rules |
