Coverdell ESA Taxable Distribution & Basis Worksheet
Clarify the tax treatment of your Coverdell ESA distribution. Understand how your education expenses and account details determine the taxable amount.
A Coverdell Education Savings Account (ESA) is a tax-advantaged account designed to help pay for educational expenses. Contributions grow tax-deferred, and distributions are tax-free if used for qualified education costs. However, if withdrawals exceed these expenses, a portion of the distribution may be taxable.
Determining if a Distribution is Taxable
A distribution from a Coverdell ESA is tax-free as long as the total amount withdrawn during the year is less than or equal to the beneficiary’s Adjusted Qualified Education Expenses (AQEE). If distributions exceed the AQEE, a portion of the earnings becomes taxable. To determine your AQEE, you first must identify the total Qualified Education Expenses (QEE), which include costs like tuition, fees, books, and supplies required for attendance at an eligible school. For students attending at least half-time, room and board can also be included.
Next, you must reduce the total QEE by any tax-free educational assistance the beneficiary received. This assistance includes scholarships, fellowship grants, veteran’s educational assistance, and employer-provided educational assistance. These benefits reduce the amount of expenses that can be offset by Coverdell ESA distributions.
A final adjustment to the QEE is required if you or anyone else claims the American Opportunity Tax Credit (AOTC) or the Lifetime Learning Credit (LLC) using the same student’s expenses. You cannot use those same expenses in your AQEE calculation. For example, if $4,000 of tuition was used to claim the AOTC, that amount must be subtracted from your QEE. This rule prevents “double-dipping” on tax benefits for the same educational costs.
Calculating Basis and Earnings in the Account
To calculate the taxable portion of a distribution, you must distinguish between the account’s basis and its earnings. The basis is the total of all contributions made to the account. This amount represents a return of your investment and is never subject to income tax when withdrawn.
The earnings portion consists of the accumulated interest, dividends, and capital gains generated by the investments. This is the part of the account that has grown tax-deferred and is potentially taxable. The taxable amount of any distribution is calculated only from these earnings, not from the basis.
You can find these figures on the annual statements from the financial institution holding the ESA. These statements detail contributions and the account’s total value. An accurate record of your basis from the prior year is needed to correctly determine the current year’s figures for the tax calculation.
The Taxable Distribution Calculation Worksheet
To determine the exact taxable amount of a distribution, use the worksheet in Chapter 6 of IRS Publication 970, Tax Benefits for Education. This worksheet allocates the distribution between the tax-free return of basis and potentially taxable earnings. The calculation requires your total distributions, AQEE, and the account’s basis.
As a numerical example, assume you took a $10,000 distribution from an ESA with a basis of $22,000. Your AQEE for the year is $8,000, and the account’s year-end value is $15,000. The first step on the worksheet is to find the excess distribution by subtracting the AQEE from the total distribution ($10,000 – $8,000 = $2,000).
Next, determine the total value of the account before the distribution by adding the year-end value to the distribution amount ($15,000 + $10,000 = $25,000). From this, subtract the account’s basis to find the total earnings ($25,000 – $22,000 = $3,000). This means the account consists of $3,000 in earnings and $22,000 in basis.
The worksheet then calculates what percentage of the account is earnings by dividing total earnings by the total account value ($3,000 / $25,000 = 0.12 or 12%). This percentage is multiplied by the excess distribution to find the taxable portion (0.12 $2,000 = $240). In this case, $240 must be reported as taxable income.
Reporting on Your Tax Return
The financial institution managing the ESA will send you Form 1099-Q, which reports the gross distribution amount. Box 1 shows the total distribution, Box 2 shows the earnings, and Box 3 shows the basis. However, you must use the taxable amount calculated from your Publication 970 worksheet for reporting.
The taxable portion of the distribution is reported on the “Other income” line of Schedule 1 (Form 1040). You should label this entry “ESA” to clarify the source of the income. This total from Schedule 1 then flows to your main Form 1040.
The taxable earnings may also be subject to a 10% additional tax. This penalty applies to the portion of earnings not used for qualified education expenses. This additional tax is calculated on Form 5329, Additional Taxes on Qualified Plans (including IRAs) and Other Tax-Favored Accounts, and reported on Schedule 2 (Form 1040).
You should keep the completed Publication 970 worksheet with your tax records. While you do not submit the worksheet with your return, it serves as documentation to support your calculation. Proper reporting ensures you accurately account for any taxable income and penalties.