If you take money out of a Coverdell Education Savings Account or a 529 savings account, you should receive a Form 1099-Q to report the distribution. If the entire amount of the distribution is used to pay qualified education expenses, the distribution would not be subject to federal income tax and you would not have to report the distribution on your tax return.
According to the IRS, to determine the amount of adjusted qualified education expenses that qualify for tax-free treatment of the earnings on the distribution from the Coverdell or 529 account, you reduce the total education expenses by any tax-free educational assistance, including the tax-free portion of scholarships and fellowships, Pell grants, veterans’ educational assistance, and educational assistance provided by an employer.
If the total distribution is more than the adjusted qualified education expenses, the earnings accumulated in the account that correspond to the excess distribution would be taxable. These distributed earnings would be reported as “Other Income” on line 21 of the beneficiary’s Form 1040.
When you receive a distribution from a Coverdell or 529 savings account, you can still claim an education credit, either the American Opportunity Credit or the Lifetime Learning Credit, or the Tuition and Fees Deduction, if you qualify. Since the credit or deduction cannot be based on the same qualifying education expenses, you would have to reduce the amount of the distribution from the Coverdell or 529 savings account that qualifies for tax-free earnings.
For example, if a student has $10,000 of qualified education expenses that are paid with a tax-free scholarship of $2,000, a student loan of $3,000, a Coverdell distribution of $1,000, and the parents pay the balance of $4,000 for which they claim an American Opportunity Credit, the earnings on the Coverdell distribution would not be taxable. The $10,000 of total expenses would be reduced by the tax-free scholarship of $2,000 and the $4,000 of expenses on which the education credit is based, leaving adjusted qualified education expenses of $4,000, which is more than the Coverdell distribution of $1,000.
If in the above example the $10,000 of expenses were paid with a scholarship of $1,000, a Coverdell distribution of $5,000 and the parents paid the balance of $4,000, a portion of the earnings on the Coverdell distribution would be taxable. The $10,000 of total expenses reduced by the $1,000 scholarship and the $4,000 expenses for which a credit was claimed leave a balance of $4,000, which is less than the Coverdell distribution.
There is a worksheet in IRS Publication 970 called “Coverdell ESA – Taxable Distributions and Basis” that will help you calculate the amount of any earnings on the distribution that are taxable.
If any earnings on the distribution are taxable, they would be taxable to the beneficiary of the Coverdell or 529 account, and not to the persons who contributed to the account.
Any distributions from a Coverdell or 529 account that are not used to pay qualified education expenses would have to be included in ordinary income and would also be subject to a 10% penalty. This penalty is calculated on Form 5329.
The timing of a distribution from a Coverdell or 529 account is important. The distribution should be taken in the same year the corresponding qualified education expenses are paid. Otherwise the distribution could be considered an excess distribution subject to tax and the penalty.
