I thought Coverdell ESA accounts were not taxable

[AndreaG · Accepted solution]

It depends on your exact situation. Your distribution is made up of your contributions which is your basis (box 3 of 1099Q) and also your earnings (box 2 of 1099Q). The contributions are never taxable. However, when your total distribution is greater than your adjusted qualified education expenses, then your earnings are taxable. 

Qualified education expenses are reduced by the amount of any tax free educational assistance, such as scholarships, that you receive. 

Qualified education expenses are also reduced by the amount of educational expenses that were used to calculate the American opportunity credit or the lifetime learning credit, if you claimed either of these credits on your 2016 tax return. 

Additionally, there is also a 10% penalty tax when you have a taxable distribution but there are exceptions to this tax such as if you received a scholarship or claimed certain education tax benefits. Please refer to page 55 of pub 970 under the heading, "additional tax on taxable distributions" for additional information. https://www.irs.gov/pub/irs-pdf/p970.pdf

Please refer to pages 52-55 of pub 970 under the headings, "distributions", "adjusted qualified education expenses", "taxable distributions, and "coordination with American opportunity credit and lifetime learning credit" if you would like to learn more. 

[deasserted]

On a related note, when I enter my 1099-Q into TurboTax, which describes my ESA, it subtracts the basis and the growth from my refund -- even though it says I won't be taxed on it.  I created the ESA account, and the distribution was used by my child for college expenses (she is not filing taxes this year).  TurboTax seems to act like the ESA came from outside our household, and is considered "income".  Why would I get thus penalized, since the ESA was created with post-tax money?  Should I not even include it, since she is the actual beneficiary? 

Or maybe it was sent to me and should have been sent to her, since my name is on the 1099-Q, just above the FBO {child's name}.  If so, can I describe that somewhere, or do I have to have the bank redo it?

I would appreciate any insight...

[KrisD15]

These accounts are funded by after-tax dollars, (although some states offer credits) it is the earnings that you get to use tax-free. HOWEVER, the funds must be used for education expenses, or it's taxed and you could incur a penalty. 

The IRS gets a copy of the 1099-Q. When you enter the 1099-Q, you must also enter the education expenses to match to it. Those expenses are usually entered from a 1098-T. 

1099-Q info

[deasserted]

I appreciate your response.  It didn't quite hit my question, so I'll be more specific: TurboTax seemed to be treating ALL my disbursement (including the basis) as taxable.  My recent research shows that I am stuck in the same boat as several people I just found on this thread:

https://www.bogleheads.org/forum/viewtopic.php?t=216633

SCENARIO: I contributed $750 in a "529" for my daughter years ago, and now we withdrew it (it grew to a paltry $761) to pay for my dependent daughter's tuition.  So then I entered the tuition into TurboTax, and my refund went up in TurboTax.  I then entered the 1099-Q disbursement, and my refund went down by the amount of the disbursement ($761).  If that disbursement had come from outside the family, I might understand.  But what TurboTax is acting like is that I get taxed twice on that money: once when I earned it and put it in the 529, and also now.

TURBOTAX SOFTWARE'S ACTION: I dug into the TurboTax Forms Mode to see why.  I appears that in the 2019 Student Info Worksheet Part VI line 18, the $761 is automatically entered as "Used for exclusion" from the Education Credit, which decreases the amount of Education Credit I get for the tuition.  They are saying that because you got 529 money from someone to pay for that tuition, you shouldn't get a tax credit for it.  I would understand this thinking if the 529 money came from another organization.  But that money didn't come from another source: I put it away for future college needs in my family.  I *think* the "Used for exclusion" box should not apply in my case, since I am both the contributor to the 529 and the receiver of the Education Credit.  Unfortunately I cannot find any instructions for how that field is/should be calculated.  How can I override that calculation?  It won't let me type in that field.

If it is not possible because it is not legal, then this 529 system is broken for parents -- how else am I supposed to put away $529 money for kids' college?  As TurboTax is now (I just experimented), I get a bigger return when I claim the 1099-Q money as "not used for college expenses" and just get taxed on the $11, but then I get the full Education Credit for tuition.  Something is broken --  either the software or the 529 concept!

I just found a doc that might explain TurboTax's thinking: page 14 in "Tax Benefits for Education" https://www.irs.gov/pub/irs-pdf/p970.pdf describing American Opportunity Credit eligibility says under Adjustments to Qualified Education Expenses: "reduce the qualified educational expenses for each academic period by the amount of tax-free educational assistance...."  The GROWTH of a 529 is tax-free, but not the basis (which was already taxed). TurboTax is reducing it by the basis, which is a mistake.

PROPOSED SOLUTION: I think I have played with every box and entry I can find related to Education in TurboTax, and I cannot get this refund right while being open & honest (the only acceptable path for me).  I think TurboTax needs to be corrected to NOT apply 529 basis money as an exclusion from Education Credits when the Education Credit tax beneficiary IS the 529 "Owner".

Do you agree?  Did I explain it okay?  Thanks for your time.

APPENDIX: Other complains about this line item, just to show I'm not alone in my confusion (all dead-ends, no need to read):

https://ttlc.intuit.com/community/taxes/discussion/can-someone-please-explain-certain-numbers-in-a-t...

https://intuit.uservoice.com/forums/31961-proseries-tax-product-suggestions/suggestions/1605065-have...

[KrisD15]

If you entered the 1098-T first, the program might allocate the expenses toward a credit. Then, when the 1099-Q is entered, there are no expenses left to allocate towards the distribution. 

It has been my experience that the program will allocate 10,000 towards a credit. The American Opportunity Tax Credit maxes out at 4,000, the Lifetime Learner at 10,000.

Please go back through the education interview, there should be a screen that states "Maximize my tax break". If you click this, the program will decide how to allocate the expenses, and the distribution might be taxed. 

The last screen should show how much expense is used for a credit and you can change it. Lower the amount by the amount of the distribution if you don't want the distribution taxed. 

"Please go back to the "Education" section. (Federal, Deductions & Credits, Scroll down to Education).

Get to the "Education Information" section (the last option on the "Here's Your Education Summary" screen).

Re-answer the interview questions until you get to the last screen. This screen should show how much of the education expenses are being allocated to a credit. 

If you are eligible for the American Opportunity Tax Credit (usually the more valuable credit), the credit maxes out at 4,000 expenses, so you wouldn't want to allocate more than that. 

If you are taking the Lifetime Learner's Credit, the credit maxes out with 10,000 expenses. 

If you want all the expenses to be applied to the scholarships/grants/1099-Q distribution, change the amount to 0." 

[deasserted]

I couldn't find the pages you mentioned in my desktop Premier version, but I believe you about TurboTax wanting to see more expenses left. 

With help of a TurboTax phone call, we finally figured out I need to use a page in "Expenses and Scholarships" asking me to enter "Books and Materials to attend school".  I had no "books or materials" receipts to enter.  But by changing it to "Yes", it opened a larger list which included "Room and board".  By entering my amounts there, I exceeded the amount of the 529, and then TurboTax gave me the full Education credit.

I still feel like TurboTax should not subtract the already-taxed 529 basis when calculating education credits (an error in TurboTax), but I at least had enough other expenses to get past it for this year.

Thank you, I'm done now.

[AmyC]

The 529 can be potentially taxed, which is what causes the confusion in the program and why you have to enter things just so. Entering the 1098-T first is preferred. By entering the 1099Q first, it is all taxable until the 1098T comes along and that is backwards to the program.

Related:  Topic No. 310 Coverdell Education Savings Accounts

[pt421]

Totally confused......my children are fully grown adults, and at no time did I set up or assist with a "Coverdell ESA" account; completely unfamiliar (pre Turbo-research) with what the term refers to.  And yet.....the Turbo Tax interview process asks questions re: something I have never been involved with.  It seems to only impact my state taxes,  in the form of minimal tax credits, but I remain 100% confused.  Unless I hear otherwise, I am going to assume it is a Turbo-snafu of some sort! 

Thanks for any feedback friends!!

Pat T. 

[KrisD15]

Some states have credits for contributing to a 529 plan. 

Contributions to a 529 plan would not be entered anywhere on the Federal return. 

The account is not limited to be for your children.

The program might simply be asking since your state might offer this credit. 

If you have not contributed to this type of plan, answer "No" and move on.