Coverdell individual retirement accounts, passed into law in 1997, were renamed Coverdell education savings accounts in 2002 because they had nothing to do with saving for retirement. Whether you're setting up the Coverdell for your child, or your Coverdell still has money in it, knowing the taxes you'll owe when you cash out lets you minimize the hit.
You can withdraw from your Coverdell whenever you want. However, you can't figure the taxes on your distributions unless you know your qualified expenses for the year. Whether you're paying for your doctorate or your child's grade school, tuition, fees, books and supplies always count as qualified expenses. For high school and below, tutoring and Internet access, as long as it's used by the student for educational purposes, count. If your kid has to wear a uniform or live on campus, that's covered, too. College kids can count room and board if they're enrolled at least half-time.
Qualified Expenses Reductions
Scholarships or grants with no taxes attached cut your costs, but they also cut your qualified expenses. Plus, any tax-free reimbursement from your employer also counts against the qualified expenses for a Coverdell. Similarly, anything you use to claim an education tax break, such as the American opportunity credit or lifetime learning credit, lower your qualified expenses. For example, if you use $10,000 of your $16,000 in expenses for the lifetime learning credit, you've got $6,000 left for the Coverdell.
You won't pay taxes on distributions for qualified educational expenses. In fact, you don't even have to mention them on a tax return. However, if you take a non-qualified withdrawal from the Coverdell, taxes are due on the earnings portion of the distribution. For example, if you take out $5,000, and 20 percent is earnings, you'll have $1,000 of taxable earnings. If you have some qualified expenses, but not enough to cover your entire distribution, prorate the earnings between qualified and non-qualified withdrawals. Say your distribution contains $1,000 earnings and your qualified expenses equals half your total distribution. You'll only have to pay taxes on $500 of the earnings.
Taxable earnings also get hit with a 10 percent penalty unless an exception applies. The entire distribution is penalty-free if you're cashing out a Coverdell you inherited or you're permanently disabled. Any earnings taxable because you got tax-free aid or claimed a tax credit also escape the penalty. Similarly, if you attend a military academy, you can take out what it would cost to attend college. Finally, you aren't penalized at all if you're just withdrawing excess contributions.
Mark Kennan is a writer based in the Kansas City area, specializing in personal finance and business topics. He has been writing since 2009 and has been published by "Quicken," "TurboTax," and "The Motley Fool."