What Happens to Funds Left Over From a Coverdell ESA?

A Coverdell Education Savings Account (ESA) helps families save for education, but unused funds can create tax and penalty concerns. Whether due to a change in plans or excess savings, account holders must decide how to handle the remaining balance. Options include rolling funds over, changing the beneficiary, or making withdrawals under specific conditions.

Distribution Process

Withdrawals from a Coverdell ESA are tax-free if used for qualified education expenses such as tuition, books, and required supplies at an accredited institution. Elementary, secondary, and higher education costs qualify, but room and board only count if the student is enrolled at least half-time in a postsecondary institution.

The account custodian manages distributions, directing funds to the beneficiary, the educational institution, or the account holder. If sent to the beneficiary or account holder, they must document that the money was used for qualified expenses; otherwise, the IRS may treat it as taxable income, potentially with penalties.

Distributions must align with the tax year in which the expenses occur. A withdrawal made in December for tuition paid in January may not qualify for tax-free treatment. Similarly, reimbursement for an expense after the tax year ends can complicate tax filings.

Age Restrictions

Coverdell ESAs have strict age limits. Contributions are allowed only until the beneficiary turns 18, unless they have special needs. After that age, no additional funds can be added.

By age 30, any remaining funds must be withdrawn or transferred to another eligible recipient. If not used for education, the IRS requires a full distribution, with earnings subject to income tax and a 10% penalty. Beneficiaries with special needs are exempt from this rule and can keep the account beyond age 30.

Nonqualified Withdrawals

Using Coverdell ESA funds for non-educational expenses triggers federal income tax and a 10% penalty on the earnings portion of the withdrawal. Contributions, which were already taxed, are not taxed again.

Some exceptions allow penalty-free withdrawals, though earnings are still subject to income tax. If the beneficiary receives a tax-free scholarship, grant, or other educational assistance, withdrawals up to that amount avoid the penalty. The same applies if the beneficiary attends a U.S. military academy. In cases of death or disability, the penalty is waived, though income tax on earnings still applies.

Rollover Options

Unused funds can be transferred to another Coverdell ESA for a qualified family member without taxes or penalties, provided IRS guidelines are met. Eligible recipients include siblings, parents, children, and first cousins. The recipient must be under 30 unless they have special needs.

The rollover must be completed within 60 days to maintain tax-deferred status, and only one rollover per beneficiary is allowed per 12-month period. Exceeding this limit could result in taxation and penalties. Additionally, total contributions across all Coverdell ESAs for a single beneficiary cannot exceed $2,000 per year, so rollovers must fit within this cap if new contributions are also being made.

Changing the Beneficiary

Another option is changing the beneficiary to a different eligible family member, allowing funds to remain in the account and continue growing tax-free if used for education. The new beneficiary must be a direct relative of the original account holder and under 30, unless they have special needs.

This is useful for families with multiple children. If one child completes their education without using all the funds, the balance can be reassigned to a younger sibling, cousin, or even a future child. However, the new beneficiary’s total Coverdell ESA contributions must still comply with the $2,000 annual limit. If combined balances exceed this threshold, excess contributions may incur a 6% excise tax. Proper planning helps avoid these penalties and ensures the funds are used effectively.

Tax Implications

The tax treatment of Coverdell ESA distributions depends on how the funds are used. Qualified withdrawals remain tax-free, while nonqualified distributions trigger income tax and penalties on earnings. If funds are not used by the time the beneficiary turns 30 and no rollover or beneficiary change occurs, the IRS requires a full distribution, leading to potential tax liabilities.

State tax treatment may differ. While federal law governs Coverdell ESA taxation, some states have additional rules. Some may not follow federal tax-free treatment of qualified withdrawals, requiring residents to report earnings as taxable income. Reviewing state-specific regulations or consulting a tax professional can help avoid unexpected liabilities.