Can You Use Coverdell Funds to Pay Student Loans?
Learn the critical rules for Coverdell ESA distributions to correctly apply funds toward education costs and avoid unintended tax consequences.
The Coverdell Education Savings Account (ESA) is a tax-advantaged account designed to help families pay for educational costs. Contributions grow tax-deferred, and withdrawals are tax-free if used for specific, approved purposes. The rules governing these accounts are precise about what constitutes a permissible withdrawal, and using funds incorrectly can lead to unexpected taxes and penalties.
Defining Qualified Education Expenses
The Internal Revenue Service (IRS) provides clear guidance on what it considers a Qualified Education Expense (QEE), with definitions varying by education level. For elementary and secondary education (kindergarten through 12th grade), QEEs include a broad range of costs.
- Tuition and fees
- Books, supplies, and equipment
- Academic tutoring and uniforms
- Expenses for special needs services for a beneficiary with special needs
For higher education, the definition covers required tuition and fees, books, supplies, and equipment necessary for enrollment. Room and board expenses can also be paid with Coverdell funds for students enrolled at least half-time. The amount that can be considered a qualified room and board expense is limited to the allowance for room and board determined by the eligible educational institution.
The purchase of a computer, peripheral equipment, software, or internet access can also be a QEE if the technology is used primarily by the beneficiary while enrolled. According to IRS Publication 970, an eligible educational institution includes any accredited public, nonprofit, or proprietary college, university, or vocational school.
Using Coverdell Funds for Student Loan Payments
A common question for families is whether Coverdell ESA funds can be used to pay down student loan debt. Paying the principal or interest on a student loan is not a Qualified Education Expense under Coverdell ESA rules. Withdrawals for this purpose are considered non-qualified distributions and are subject to tax and penalties.
The reasoning for this rule is the distinction between a direct cost of education and a financing mechanism. QEEs are expenses for enrolling in and attending an institution, such as tuition or books. A student loan is a financial tool used to pay for those direct costs, and its repayment is considered a separate financial transaction, not a direct educational expense.
Tax Consequences of Non-Qualified Withdrawals
Using Coverdell ESA funds for a non-qualified purpose, such as paying a student loan, triggers specific tax consequences. When a non-qualified withdrawal is made, the distribution is separated into two parts: the original contributions (the basis) and the investment earnings. The portion of the withdrawal representing the return of contributions is always tax-free and penalty-free.
The earnings portion of the non-qualified withdrawal, however, faces two consequences. First, these earnings are included in the beneficiary’s gross income for the year and are subject to ordinary income tax. Second, these same earnings are subject to an additional 10% federal tax penalty. This penalty is designed to discourage the use of the tax-advantaged account for purposes other than education.
For example, a Coverdell ESA holds $10,000, consisting of $6,000 in contributions and $4,000 in earnings. If the beneficiary takes a $2,000 non-qualified distribution to pay a student loan, the tax impact is calculated on the earnings portion. Since 40% of the account is earnings ($4,000 / $10,000), 40% of the $2,000 withdrawal, or $800, is considered earnings. This $800 would be reported as taxable income and would also incur an $80 penalty (10% of $800).
Permissible Actions for Remaining Coverdell Funds
Families with leftover funds in a Coverdell ESA have several options to avoid tax consequences. A primary regulation is that any money remaining in the account must be distributed within 30 days after the beneficiary reaches age 30, unless the beneficiary has special needs. If the funds are not used or moved by this deadline, the earnings become taxable to the beneficiary and are subject to the 10% penalty.
Before the beneficiary reaches the age 30 limit, one action is to change the designated beneficiary of the account. The new beneficiary must be an eligible member of the original beneficiary’s family and under the age of 30. The IRS defines “family member” broadly to include siblings, stepsiblings, children, parents, nieces, nephews, and first cousins. This allows the tax-advantaged savings to be passed to a younger relative who can use it for their own education.
Another option is to roll the Coverdell ESA assets into a 529 plan. This can be done for the same beneficiary or for another eligible family member. A rollover from a Coverdell ESA to a 529 plan is a qualified transaction, so it does not trigger taxes or penalties if the transfer is completed within 60 days of the distribution. This move can be advantageous because 529 plans do not have an age 30 distribution requirement, allowing the funds to remain invested for a longer period.