Coverdell ESA Distributions

[Fuzzy7562]

We contributed to a CESA for our daughter's education.  Fortunately (or not in this case, I think), she earned a merit scholarship and I transferred my GI Bill eligibility to her.  That pretty much covered her college education.  She's graduating this summer and we are biting the tax bullet on taking the full amount out (she doesn't contemplate grad school and is not anticipating children).  So, this distribution is not education related.  It's going into a brokerage account for her future use in whatever her investment desires are for the future.  I'm doing her taxes and right now, the $81K gross distribution on the 1099Q is giving us a $14K tax bite.  Does that sound "normal?"  Also, Tax is asking if the distribution was a return of our Coverdell contribution?  I'm not sure exactly what that means... Sorry for the long story and thanks.  Bob H.

[AmyC]

You are not required to distribute it all at once. You can and that does boost the tax bracket. You could do a small distribution each year and/ or leave some in case she changes her mind later about graduate school.

Your Coverdell contributions over the years to save up are the cost basis. So, if you put in $50k and are taking out $80k, only earnings of $30k is taxable. It should show on the 1099-Q the basis and earnings.

[Hal_Al]

Q.  I'm doing her taxes and right now, the $81K gross distribution on the 1099Q is giving us a $14K tax bite.  Does that sound "normal?"  

A. Maybe, depending on your tax bracket.  Several issues come up. First, as AmyC pointed out, only the earnings portion is taxable.  The $14K may also include the 10% non qualified distribution penalty (the penalty is also on the earnings, not the total  distribution), which you might be able to avoid.  Depending on her age and other income, the "kiddie tax" may apply (she's taxed at the parent's marginal tax rate).

There are  exceptions to the penalty, if the distribution was only taxable because the student had scholarships or the parents use some of the tuition to claim the education  tax credit.  

There is some disagreement on the timing of the distribution, in order to claim the penalty exception. “Most believe and have written that the distribution must be made in the same year that the scholarship paid for the tuition expense,” Peter J. Greco, CPA, founder and chief tax strategist at the CSI Group, says. “However, IRS 970 is silent as to when the money must be withdrawn. If Congress is trying to encourage 529 plans, then it makes good policy sense that the withdrawals can be made any time prior to graduation.”

Coverdell ESA assets  must be withdrawn by the time the beneficiary reaches the age of 30.

[Fuzzy7562]

Thanks, AmyC.  The 1099Q had nothing in the basis or earnings blocks.  However, I added them in the TurboTax worksheet.

[Fuzzy7562]

Thanks, Hal_Al.  Yes, we were also hit by the parents marginal tax rate.

[KrisD15]

To avoid the penalty tax, I believe the distribution must match the expenses (or exceptions to excise tax) of the coordinating year OR THE PREVIOUS YEAR if the distribution is made within the first six months of the following year. 

Therefor I believe you could make a distribution before June 1 2022,  to cover expenses for 2021 and 2022 and not pay the penalty on that distribution. 

The beneficiary could continue to take distributions until age 30 in which case the distributions would be taxed at her tax rate. 

The account could also be rolled over to a family member. 

However, if the transfer as been made, those options are no longer available. 

ADDITIONALLY you do need to have the basis and earnings reported separately so the tax is only based on the earnings portion. I  think the transfer to a brokerage account is considered a distribution, not a roll-over. 

According to the IRS:

"The excise tax doesn't apply if excess contributions made during 2021 (and any earnings on them) are distributed before the first day of the sixth month of the
following tax year (June 1, 2022, for a calendar year taxpayer).
However, you must include the distributed earnings in gross income for the year in which the excess contribution was made.

According to the IRS:

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

"Adjusted qualified education expenses (AQEE). 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 fellowship grants
(see Tax-Free Scholarships and Fellowship Grants in
chapter 1);
• Veterans' educational assistance (see Veterans' Benefits in chapter 1);
• The tax-free part of Pell grants (see Pell Grants and
Other Title IV Need-Based Education Grants in chapter 1);
• Employer-provided educational assistance (see chapter 10); 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 (AQEE). "

"Members of the beneficiary's family. For these purposes, the beneficiary's family includes the beneficiary's
spouse and the following other relatives of the beneficiary.
1. Son, daughter, stepchild, foster child, adopted child,
or a descendant of any of them.
2. Brother, sister, stepbrother, or stepsister.
3. Father or mother or ancestor of either.
4. Stepfather or stepmother.
5. Son or daughter of a brother or sister.
6. Brother or sister of father or mother.
7. Son-in-law, daughter-in-law, father-in-law,
mother-in-law, brother-in-law, or sister-in-law.
8. The spouse of any individual listed above.
9. First cousin."

Pub 970