Distributions(p49)

The designated beneficiary of a Coverdell ESA can take a distribution at any time. Whether the distributions are tax free depends, in part, on whether the distributions are equal to or less than the amount of adjusted qualified education expenses (defined below) that the beneficiary has in the same tax year.

See Table 7-3 for highlights.

Question	Answer
Is a distribution from a Coverdell ESA to pay for a designated beneficiary's qualified education expenses tax free?	Generally, yes, to the extent the amount of the distribution is not more than the designated beneficiary's adjusted qualified education expenses.
After the designated beneficiary completes his or her education at an eligible educational institution, can amounts remaining in the Coverdell ESA be distributed?	Yes. Amounts must be distributed when the designated beneficiary reaches age 30, unless he or she is a special needs beneficiary. Also, certain transfers to members of the beneficiary's family are permitted.
Does the designated beneficiary need to be enrolled for a minimum number of courses to take a tax-free distribution?	No.

To determine if total distributions for the year are more than the amount of qualified education expenses, reduce total qualified education expenses by any tax-free educational assistance. Tax-free educational assistance includes:

• The tax-free part of scholarships and fellowships (see chapter 1),
• Veterans' educational assistance (see chapter 1),
• Pell grants (see chapter 1),
• Employer-provided educational assistance (see chapter 11), and
• Any other nontaxable (tax-free) payments (other than gifts or inheritances) received as educational assistance.

The amount you get by subtracting tax-free educational assistance from your total qualified education expenses is your adjusted qualified education expenses.

Generally, distributions are tax free if they are not more than the beneficiary's adjusted qualified education expenses for the year. Do not report tax-free distributions (including qualifying rollovers) on your tax return.

A portion of the distributions is generally taxable to the beneficiary if the total distributions are more than the beneficiary's adjusted qualified education expenses for the year.

This is the part of the total distribution that is more than the beneficiary's adjusted qualified education expenses for the year.

You will receive a Form 1099-Q for each of the Coverdell ESAs from which money was distributed in 2010. The amount of your gross distribution will be shown in box 1. For 2010, instead of dividing the gross distribution between your earnings (box 2) and your basis (already-taxed amount) (box 3), the payer or trustee may report the fair market value (account balance) of the Coverdell ESA as of December 31, 2010. This will be shown in the blank box below boxes 5 and 6.

The amount contributed from survivor benefits (see Military death gratuity, earlier) is treated as part of your basis and will not be taxed when distributed.

The taxable portion is the amount of the excess distribution that represents earnings that have accumulated tax free in the account. Figure the taxable portion for 2010 as shown in the following steps.

1. Multiply the total amount distributed by a fraction. The numerator is the basis (contributions not previously distributed) at the end of 2009 plus total contributions for 2010 and the denominator is the value (balance) of the account at the end of 2010 plus the amount distributed during 2010.
2. Subtract the amount figured in (1) from the total amount distributed during 2010 . The result is the amount of earnings included in the distribution(s).
3. Multiply the amount of earnings figured in (2) by a fraction. The numerator is the adjusted qualified education expenses paid during 2010 and the denominator is the total amount distributed during 2010.
4. Subtract the amount figured in (3) from the amount figured in (2). The result is the amount the beneficiary must include in income.

The taxable amount must be reported on Form 1040 or Form 1040NR, line 21.

You received an $850 distribution from your Coverdell ESA, to which $1,500 had been contributed before 2010. There were no contributions in 2010. This is your first distribution from the account, so your basis in the account on December 31, 2009, was $1,500. The value (balance) of your account on December 31, 2010, was $950. You had $700 of adjusted qualified education expenses (AQEE) for the year. Using the steps above, figure the taxable portion of your distribution as follows.

	1.	$850 (distribution)	×	$1,500 basis + $0 contributions $950 value + $850 distribution
		= $708 (basis portion of distribution)

	2.	$850 (distribution) − $708 (basis portion of distribution)
		= $142 (earnings included in distribution)

	3.	$142 (earnings)	×	$700 AQEE   $850 distribution
		= $117 (tax-free earnings)

	4.	$142 (earnings) − $117 (tax-free earnings) = $25 (taxable earnings)

You must include $25 in income as distributed earnings not used for qualified education expenses. Report this amount on Form 1040, line 21, listing the type and amount of income on the dotted line.

Worksheet 7-3, at the end of this chapter, can help you figure your adjusted qualified education expenses, how much of your distribution must be included in income, and the remaining basis in your Coverdell ESA(s).

The American opportunity or lifetime learning credit can be claimed in the same year the beneficiary takes a tax-free distribution from a Coverdell ESA, as long as the same expenses are not used for both benefits. This means the beneficiary must reduce qualified higher education expenses by tax-free educational assistance, and then further reduce them by any expenses taken into account in determining an American opportunity or lifetime learning credit.

Derek Green had $5,800 of qualified higher education expenses for 2010, his first year in college. He paid his college expenses from the following sources. 

	Partial tuition scholarship (tax free)	$1,500
	Coverdell ESA distribution	1,000
	Gift from parents	2,100
	Earnings from part-time job	1,200

Of his $5,800 of qualified higher education expenses, $4,000 was tuition and related expenses that also qualified for an American opportunity credit. Derek's parents claimed a $2,500 American opportunity credit (based on $4,000 expenses) on their tax return.

Before Derek can determine the taxable portion of his Coverdell ESA distribution, he must reduce his total qualified higher education expenses. 

	Total qualified higher education expenses	$5,800
	Minus: Tax-free educational assistance	−1,500
	Minus: Expenses taken into account in  figuring American opportunity credit	−4,000
	Equals: Adjusted qualified higher education  expenses (AQHEE)	$  300

Since the adjusted qualified higher education expenses ($300) are less than the Coverdell ESA distribution ($1,000), part of the distribution will be taxable. The balance in Derek's account was $1,800 on December 31, 2010. Prior to 2010, $2,100 had been contributed to this account. Contributions for 2010 totaled $400. Using the four steps outlined earlier, Derek figures the taxable portion of his distribution as shown below.

	1.	$1,000 (distribution)	×	$2,100 basis + $400 contributions $1,800 value + $1,000 distribution
		= $893 (basis portion of distribution)

	2.	$1,000 (distribution) − $893 (basis portion of distribution)
		= $107 (earnings included in distribution)

	3.	$107 (earnings)	×	$300 AQHEE    $1,000 distribution
		= $32 (tax-free earnings)

	4.	$107 (earnings) − $32 (tax-free earnings) = $75 (taxable earnings)

Derek must include $75 in income (Form 1040, line 21). This is the amount of distributed earnings not used for adjusted qualified higher education expenses.

If a designated beneficiary receives distributions from both a Coverdell ESA and a QTP in the same year, and the total distribution is more than the beneficiary's adjusted qualified higher education expenses, those expenses must be allocated between the distribution from the Coverdell ESA and the distribution from the QTP before figuring how much of each distribution is taxable. The following two examples illustrate possible allocations.

In 2010, Beatrice graduated from high school and began her first semester of college. That year, she had $1,000 of qualified elementary and secondary education expenses (QESEE) for high school and $3,000 of qualified higher education expenses (QHEE) for college. To pay these expenses, Beatrice withdrew $800 from her Coverdell ESA and $4,200 from her QTP. No one claimed Beatrice as a dependent, nor was she eligible for an education credit. She did not receive any tax-free educational assistance in 2010. Beatrice must allocate her total qualified education expenses between the two distributions.

1.

Beatrice knows that tax-free treatment will be avail- able if she applies her $800 Coverdell ESA distribution toward her $1,000 of qualified education expenses for high school. The qualified expenses are greater than the distribution, making the $800 Coverdell ESA distribution tax free.

	2.	Next, Beatrice matches her $4,200 QTP distribution to her $3,000 of QHEE, and finds she has an excess QTP distribution of $1,200 ($4,200 QTP − $3,000 QHEE). She cannot use the extra $200 of high school expenses (from (1) above) against the QTP distribution because those expenses do not qualify a QTP for tax-free treatment.
	3.	Finally, Beatrice figures the taxable and tax-free portions of her QTP distribution based on her $3,000 of QHEE. (See Figuring the Taxable Portion of a Distribution in chapter 8 for more information.)

Assume the same facts as in Example 1, except that Beatrice withdrew $1,800 from her Coverdell ESA and $3,200 from her QTP. In this case, she allocates her qualified education expenses as follows.

1. Using the same reasoning as in Example 1, Beatrice matches $1,000 of her Coverdell ESA distribution to her $1,000 of QESEE—she has $800 of her distribution remaining.
2. Because higher education expenses can also qualify a Coverdell ESA distribution for tax-free treatment, Beatrice allocates her $3,000 of QHEE between the remaining $800 Coverdell ESA and the $3,200 QTP distributions ($4,000 total).

   $3,000 QHEE

   ×

   $800 ESA distribution $4,000 total distribution

   =

   $600 QHEE (ESA)

   
   

   $3,000 QHEE

   ×

   $3,200 QTP distribution $4,000 total distribution

   =

   $2,400 QHEE (QTP)

   
   
3. Beatrice then figures the taxable part of her:
   1. Coverdell ESA distribution based on qualified education expenses of $1,600 ($1,000 QESEE + $600 QHEE). See Figuring the Taxable Portion of a Distribution, earlier in this chapter.  
      
   2. QTP distribution based on her $2,400 of QHEE (see Figuring the Taxable Portion of a Distribution in chapter 8).

If you have a loss on your investment in a Coverdell ESA, you may be able to deduct the loss on your income tax return. You can deduct the loss only when all amounts from that account have been distributed and the total distributions are less than your unrecovered basis. Your basis is the total amount of contributions to that Coverdell ESA. You claim the loss as a miscellaneous itemized deduction on Schedule A (Form 1040), line 23 (Schedule A (Form 1040NR), line 11), subject to the 2%-of-adjusted- gross-income limit.

If you have distributions from more than one Coverdell ESA account during a year, you must combine the information (amount of distribution, basis, etc.) from all such accounts in order to determine your taxable earnings for the year. By doing this, the loss from one ESA account reduces the distributed earnings (if any) from any other ESA account. For examples of the calculation, see Losses on QTP Investments in chapter 8 under Figuring the Taxable Portion of a Distribution.

Generally, if you receive a taxable distribution, you also must pay a 10% additional tax on the amount included in income.

The 10% additional tax does not apply to distributions:

1. Paid to a beneficiary (or to the estate of the designated beneficiary) on or after the death of the designated beneficiary.
2. Made because the designated beneficiary is disabled. A person is considered to be disabled if he or she shows proof that he or she cannot do any substantial gainful activity because of his or her physical or mental condition. A physician must determine that his or her condition can be expected to result in death or to be of long-continued and indefinite duration.
3. Included in income because the designated beneficiary received:
   1. A tax-free scholarship or fellowship (see  
      chapter 1),
   2. Veterans' educational assistance (see chapter 1),
   3. Employer-provided educational assistance (see chapter 11), or
   4. Any other nontaxable (tax-free) payments (other than gifts or inheritances) received as educational assistance.
4. Made on account of the attendance of the designated beneficiary at a U.S. military academy (such as the USMA at West Point). This exception applies only to the extent that the amount of the distribution does not exceed the costs of advanced education (as defined in section 2005(d)(3) of title 10 of the U.S. Code) attributable to such attendance.
5. Included in income only because the qualified education expenses were taken into account in determining the American opportunity or lifetime learning credit (see Coordination With American Opportunity and Lifetime Learning Credits, earlier).
6. Made before June 1, 2011, of an excess 2010 contribution (and any earnings on it). The distributed earnings must be included in gross income for the year in which the excess contribution was made.

Exception (3) applies only to the extent the distribution is not more than the scholarship, allowance, or payment.

Use Part II of Form 5329, Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts, to figure any additional tax. Report the amount on Form 1040, line 58, or Form 1040NR, line 56.

Any assets remaining in a Coverdell ESA must be distributed when either one of the following two events occurs.

1. The designated beneficiary reaches age 30. In this case, the remaining assets must be distributed within 30 days after the beneficiary reaches age 30. However, this rule does not apply if the beneficiary is a special needs beneficiary.
2. The designated beneficiary dies before reaching age 30. In this case, the remaining assets must generally be distributed within 30 days after the date of death.

If a Coverdell ESA is transferred to a surviving spouse or other family member as the result of the death of the designated beneficiary, the Coverdell ESA retains its status. ("Family member" was defined earlier under Rollovers.) This means the spouse or other family member can treat the Coverdell ESA as his or her own and does not need to withdraw the assets until he or she reaches age 30. This age limitation does not apply if the new beneficiary is a special needs beneficiary. There are no tax consequences as a result of the transfer.

When a total distribution is made because the designated beneficiary either reached age 30 or died, the earnings that accumulated tax free in the account must be included in taxable income. You determine these earnings as shown in the following two steps.

1. Multiply the amount distributed by a fraction. The numerator is the basis (contributions not previously distributed) at the end of 2009 plus total contributions for 2010 and the denominator is the balance in the account at the end of 2010 plus the amount distributed during 2010.
2. Subtract the amount figured in (1) from the total amount distributed during 2010. The result is the amount of earnings included in the distribution.

For an example, see steps (1) and (2) of the Example under Figuring the Taxable Portion of a Distribution, earlier.

The beneficiary or other person receiving the distribution must report this amount on Form 1040, line 21, or Form 1040NR, line 21, listing the type and amount of income on the dotted line.

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Worksheet 7-3 Instructions. Coverdell ESA—Taxable Distributions and Basis Line G. Enter the total distributions received from all Coverdell ESAs during 2010. Do not include amounts rolled over to another ESA within 60 days (only one rollover is allowed during any 12-month period). Also, do not include excess contributions that were distributed with the related earnings (or less any loss) before the first day of the sixth month of the tax year following the year for which the contributions were made. Line 2. Your basis (amount already taxed) in this Coverdell ESA as of December 31, 2009, is the total of:    • All contributions to this Coverdell ESA before 2010  • Minus the tax-free portion of any distributions from this Coverdell ESA before 2010.   If your last distribution from this Coverdell ESA was before 2010, you must start with the basis in your account as of the end of the last year in which you took a distribution. For years before 2002, you can find that amount on the last line of the worksheet in the Instructions for Form 8606, Nondeductible IRAs, that you completed for that year. For years after 2001, you can find that amount by using the ending basis from the worksheet in Publication 970 for that year. You can determine your basis in this Coverdell ESA as of December 31, 2009, by adding to the basis as of the end of that year any contributions made to that account after the year of the distribution and before 2010. Line 4. Enter the total distributions received from this Coverdell ESA in 2010. Do not include amounts rolled over to another Coverdell ESA within 60 days (only one rollover is allowed during any 12-month period).   Also, do not include excess contributions that were distributed with the related earnings (or less any loss) before the first day of the sixth month of the tax year following the year of the contributions. Line 7. Enter the total value of this Coverdell ESA as of December 31, 2010, plus any outstanding rollovers contributed to the account after 2009, but before the end of the 60-day rollover period. A statement should be sent to you by January 31, 2011, for this Coverdell ESA showing the value on December 31, 2010.   A rollover is a tax-free withdrawal from one Coverdell ESA that is contributed to another Coverdell ESA. An outstanding rollover is any amount withdrawn within 60 days before the end of 2010 (November 2 through December 31) that was rolled over after December 31, 2010, but within the 60-day rollover period.

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Worksheet 7-3. Coverdell ESA—Taxable Distributions and Basis How to complete this worksheet.   •   •   • Complete Part I, lines A through H, on only one worksheet. Complete a separate Part II, lines 1 through 15, for each of your Coverdell ESAs. Complete Part III, the Summary (line 16), on only one worksheet. Part I. Qualified Education Expenses (Complete for total expenses)        A. Enter your total qualified education expenses for 2010    A.  B. Enter those qualified education expenses paid for with tax-free educational assistance (for example, tax-free scholarships, veterans' educational benefits, Pell grants, employer-provided educational assistance)    B.        C. Enter those qualified higher education expenses deducted on Schedule C or C-EZ (Form 1040), Schedule F (Form 1040), or as a miscellaneous itemized deduction on Schedule A (Form 1040 or 1040NR)    C.        D. Enter those qualified higher education expenses on which an American opportunity or lifetime learning credit was based    D.        E. Add lines B, C, and D    E.  F. Subtract line E from line A. This is your adjusted qualified education expense for 2010    F.  G. Enter your total distributions from all Coverdell ESAs during 2010. Do not include rollovers or the return of excess contributions (see instructions)    G.  H. Divide line F by line G. Enter the result as a decimal (rounded to at least 3 places). If the result is 1.000 or more, enter 1.000    H. .       Part II. Taxable Distributions and Basis (Complete separately for each account)  1. Enter the amount contributed to this Coverdell ESA for 2010, including contributions made for 2010 from January 1, 2011, through April 15, 2011. Do not include rollovers or the return of excess contributions    1.  2. Enter your basis in this Coverdell ESA as of December 31, 2009 (see instructions)    2.  3. Add lines 1 and 2    3.  4. Enter the total distributions from this Coverdell ESA during 2010. Do not include rollovers or the return of excess contributions (see instructions)    4.  5. Multiply line 4 by line H. This is the amount of adjusted qualified education expense attributable to this Coverdell ESA    5.        6. Subtract line 5 from line 4    6.        7. Enter the total value of this Coverdell ESA as of December 31, 2010, plus any outstanding rollovers (see instructions)    7.        8. Add lines 4 and 7    8.        9. Divide line 3 by line 8. Enter the result as a decimal (rounded to at least 3 places). If the result is 1.000 or more, enter 1.000    9. .             10. Multiply line 4 by line 9. This is the amount of basis allocated to your distributions, and is tax free   10.   Note. If line 6 is zero, skip lines 11 through 13, enter -0- on line 14, and go to line 15.       11. Subtract line 10 from line 4   11. 12. Divide line 5 by line 4. Enter the result as a decimal (rounded to at least 3 places). If the result is 1.000 or more, enter 1.000   12. .             13. Multiply line 11 by line 12. This is the amount of qualified education expenses allocated to your distributions, and is tax free   13. 14. Subtract line 13 from line 11. This is the portion of the distributions from this Coverdell ESA in 2010 that you must include in income   14. 15. Subtract line 10 from line 3. This is your basis in this Coverdell ESA as of December 31, 2010   15. Part III. Summary (Complete only once)       16. Taxable amount. Add together all amounts on line 14 for all your Coverdell ESAs. Enter here and include on Form 1040, line 21, or Form 1040NR, line 21, listing the type and amount of income on the dotted line   16.