Taxes on Cashing Out a Coverdell Education IRA

When you set up a Coverdell education savings account, called a Coverdell ESA, Uncle Sam gives you some nice tax breaks to help pay for a child’s education. The accounts are sometimes called education IRAs, but they really aren't IRAs, despite some similarities. The tax benefits apply only to money used for education costs as defined by the Internal Revenue Service. You have to follow IRS rules or lose the tax break, and you might have to pay penalties besides.

Contributions can be made to a Coverdell ESA as long as the child who is the beneficiary is under age 18 or is a special-needs student. Anyone can open or contribute to an ESA, including parents, friends, relatives and the beneficiary. Even organizations or employers can put money into a Coverdell account. The only limitations on contributions are that they are not tax deductible and the total added to a Coverdell ESA a single year can’t be more than $2,000.

Because contributions are not tax deductible, you’ve already paid taxes on them. Consequently, these contributions are not taxed while in the account or when they are withdrawn. Investment earnings in a Coverdell ESA are not taxable as long as they remain in the account. In addition, all earnings that are taken out and used to pay qualified educational expenses are tax exempt.

You can cash in part or all of a Coverdell account to pay for tuition, books and academic fees. A beneficiary can even use the money to buy a computer for school. Withdrawals can be used for expenses related to primary, secondary and post-secondary schooling.

If you cash in a Coverdell ESA, part of the withdrawal is considered earnings. When a withdrawal exceeds qualified educational expenses, the excess portion that is earnings is taxable. Suppose you withdraw $10,000 and qualified expenses only come to $8,000, meaning you took out $2,000 too much. The portion of the extra $2,000 that counts as earnings is taxable. In addition, you may have to pay a 10-percent penalty tax on the portion of the excess withdrawal that counts as taxable earnings. The IRS waives the penalty if you took the money out because you become disabled, or received other financial aid such as a scholarship or grant.

The IRS says a beneficiary is supposed to use up all of the money in a Coverdell ESA by the beneficiary's 30th birthday. This time limit is waived for special-needs beneficiaries. All investment earnings remaining in the account afterward become taxable and may be subject to the 10-percent penalty tax as well, but you have the option of changing the beneficiary on the account. For example, you can change the beneficiary to a younger brother or sister who is between 18 and 30 to preserve the tax-exempt status of the money in the account.