Taxable Withdrawals and Penalty Rules

Income tax, and possibly a penalty, will apply to earnings that are withdrawn in a year when there are not enough qualified expenditures.

When the amount you withdraw from your Coverdell account is greater than the qualified education expenses for the year, the beneficiary (student) has to pay tax on the earnings portion of the excess. Unless an exception applies, the student also has to pay a 10% penalty tax for making a nonqualifying use of money from a Coverdell account.

Amount Taxable

You don't have to report the entire distribution as taxable income. Only the earnings portion is taxable. This is determined the same way as for a traditional IRA for which you've made nondeductible contributions. Here's the basic idea:

1. Determine your basis for the Coverdell account. This is the total of all contributions made over the years, reduced by the basis portion of any withdrawals taken in previous years.
2. Use this number to determine the percentage of the overall account value that represents earnings.
3. Determine how much of the withdrawal exceeded the qualified education expenses for the year.
4. Multiply this number by the earnings percentage to determine the amount of income.

Example: Suppose your contributions to a Coverdell account over the years added up to $3,000. During 2005 you took out $1,500, but had only $1,000 of qualified education expenses. At the end of 2005 the account value was $3,500. That means there would have been $5,000 in the account if you hadn't taken any money out, consisting of $3,000 in contributions and $2,000 of earnings. The earnings percentage is 40% ($2,000 divided by $5,000). The amount of income is $200 (40% times $500, the part of the withdrawal that wasn't used for qualified education expenses).

Notice that the earnings amount is based on the value of the Coverdell account. Unlike a regular investment account, these accounts can be treated as having earnings even if they never received any income or sold anything for a profit. If the value of the account has gone up (for example, because the account is invested in stocks that climbed in value), it's treated as having earnings. By the same token, an account can have zero earnings even after it has received interest and dividends, if it also has investments that have declined in value.
 

Character of Income

If account earnings end up being taxable, they're taxed as ordinary income. You don't get the benefit of long-term capital gains rates even if the earnings came from long-term investments in the Coverdell account.

Who Pays?

The tax law says the income is taxable to the "distributee." In Publication 970, the IRS says the beneficiary pays the tax, based on the apparent assumption that the withdrawal goes to the beneficiary, or is used for the benefit of the beneficiary.

Penalty

Subject to exceptions explained below, a 10% "addition to tax" — in other words, a penalty — applies when you report taxable earnings from a Coverdell account. The idea here is to discourage people from using a Coverdell account as a way to postpone paying tax on investment earnings if the money isn't going to be used for education. Congress provided the following perfectly logical exceptions to this penalty:

• Death or disability of beneficiary. There's no penalty for distributions made after the death of the designated beneficiary, or because the designated beneficiary became disabled.
• Scholarships and other assistance. As noted earlier, some forms of scholarships and other assistance reduce the amount of qualified education expenses. When that happens, you can still withdraw from the Coverdell account free of penalty (but not free of tax) up to the amount of the assistance that prevented the payments from qualifying.
• Taxable by your choice. In a given year, you may choose to pay tax on a withdrawal from a Coverdell account so you can claim another tax break, such as the Hope Scholarship Credit. When you do that, the beneficiary has to pay tax on the earnings portion of the withdrawal but there's no penalty in this case.
• Corrective distributions. If you're taking money out to correct an excess contribution, the penalty doesn't apply to the earnings portion of the distribution. Corrective distributions are discussed below.

There is also a special exception for students attending a U.S. military academy.

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