Education savings accounts are tax-free only if you use the money for may have access to education expenses

Money you put into an education savings account (also called a Coverdell ESA) grows without federal income tax, and withdrawals are tax-free as long as you spend them on may have access to education costs. If you withdraw money for anything else, you pay income tax on the earnings portion plus a 10 percent penalty. The tax treatment depends entirely on what you spend the money on and which type of account you opened.

The IRS publishes a specific list of what counts as a may have access to education expense. It includes tuition, fees, books, supplies, equipment, room and board (if the student is at least half-time), and up to $35,000 per year in K-12 tuition at any school, public or private. It also covers up to $35,000 in student loan repayment and up to $35,000 in apprenticeship program costs. Anything outside that list triggers tax and the penalty.

Key Takeaways

  • Withdrawals from a Coverdell ESA are tax-free only when spent on the IRS list of may have access to education expenses, which includes tuition, fees, books, room and board, and up to $35,000 per year in K-12 tuition.
  • Non-may have access to withdrawals are taxed as ordinary income on the earnings portion, plus a 10 percent federal penalty, though some exceptions exist for scholarships and disability.
  • Contributions to a Coverdell ESA are made with after-tax dollars and do not reduce your taxable income, but the growth inside the account is never taxed.
  • You must withdraw all money from a Coverdell ESA by age 30, and any remaining balance is subject to tax and penalty unless transferred to a family member's account.
  • State tax treatment varies: some states tax Coverdell earnings, while others follow federal rules, so check your state's rules before opening an account.

How the tax-free growth works inside the account

When you open a Coverdell ESA, you deposit money that has already been taxed (you cannot deduct it from your income). That money then grows through interest, dividends, or investment gains, and none of that growth is taxed while it sits in the account. This is the main tax advantage: a regular savings account would tax you on the interest each year, but a Coverdell does not.

The account can hold up to $2,000 per beneficiary per year (as of 2024), and you can contribute until the beneficiary turns 18. If you have multiple children, you can open a separate Coverdell for each one. The money can stay in the account until the beneficiary turns 30, giving it years to grow tax-free.

What happens when you withdraw money for non-may have access to expenses

If you take money out of a Coverdell ESA and do not spend it on a may have access to education expense, the IRS taxes you on the earnings portion of that withdrawal. The earnings are the interest and investment gains, not your original contributions — those come out tax-free. You also pay a 10 percent penalty on the earnings.

For example, if you contributed $5,000 and the account grew to $6,500, and you withdraw $3,000 for a non-may have access to expense, the IRS calculates what portion of that $3,000 is earnings. If $600 of it is earnings, you owe income tax on $600 plus a $60 penalty. Your tax rate depends on your overall income and tax bracket.

Some withdrawals are exempt from the penalty (though not from income tax on earnings). These include withdrawals made because the beneficiary received a scholarship, died, or became disabled. You still owe tax on the earnings, but the 10 percent penalty does not apply.

State tax treatment varies by location

Federal tax rules apply everywhere, but your state may have its own rules for Coverdell accounts. Some states do not tax the earnings at all, treating them the same way the federal government does. Other states tax the earnings as state income, even though they are not taxed federally.

A few states offer state tax deductions or credits for Coverdell contributions, which means you can reduce your state taxable income by the amount you contribute. This is separate from the federal rule (which does not allow a deduction). Before you open an account, check your state's tax department website or ask a tax preparer whether your state taxes Coverdell earnings or offers any deduction for contributions.

The age 30 deadline and what it means for taxes

All money must leave a Coverdell ESA by the time the beneficiary turns 30. If there is still money in the account after that birthday, it is subject to income tax and the 10 percent penalty, even if you use it for education. The only way to avoid this is to transfer the remaining balance to another family member's Coverdell ESA before the deadline.

A family member includes a sibling, cousin, parent, or spouse of the original beneficiary. If you transfer the money to a relative's account, it counts as a contribution to their account for that year, so you have to stay within the $2,000 annual contribution limit. Plan ahead if you know money will be left over — transferring it takes a few weeks, so do not wait until the last day of the month the beneficiary turns 30.

Coordinating with other education tax benefits

You cannot use the same money for both a Coverdell withdrawal and another education tax benefit in the same year. For example, if you withdraw $3,000 from a Coverdell for tuition and also claim the American Opportunity Tax Credit for the same tuition, the IRS will disallow one of them. You have to choose which benefit to use for which expense.

The same rule applies if you use money from a 529 plan and a Coverdell in the same year for the same student. You can use both accounts, but you have to split the expenses between them or use one account for one expense and the other account for a different expense. Keep records of what you spent each withdrawal on, because the IRS may ask.

Reporting Coverdell activity on your tax return

If you only make may have access to withdrawals from a Coverdell, you do not report anything on your federal tax return. The account is invisible to the IRS as long as the money goes to may have access to expenses.

If you make a non-may have access to withdrawal, you report it on Form 1099-Q, which the account custodian sends to you and the IRS. You then report the taxable earnings and penalty on your Form 1040. A tax preparer can help you calculate the earnings portion and the penalty, or you can use the IRS worksheet in Publication 970 to do it yourself.

Frequently Asked Questions

Do I have to pay taxes on money I contribute to a Coverdell ESA?

No. Contributions are made with money you have already paid income tax on. You cannot deduct the contribution from your income on your tax return. The tax advantage comes from the growth inside the account, which is never taxed as long as you use it for may have access to expenses.

What if I use Coverdell money for room and board but the student is not enrolled full-time?

Room and board is only a may have access to expense if the student is enrolled at least half-time in a degree or certificate program. If the student is part-time or not enrolled, room and board is not may have access to, and you owe tax and penalty on the earnings portion of that withdrawal. Check the school's enrollment status before you withdraw.

Can I roll a Coverdell ESA into a 529 plan to avoid the age 30 deadline?

No direct rollover exists between Coverdell and 529 accounts. Your only option is to transfer the remaining balance to another family member's Coverdell before age 30. If you cannot do that, the money is taxed and penalized. Plan ahead and consider whether a 529 plan might be a better fit if you want more time.

Do I owe taxes if my child gets a scholarship and I withdraw the Coverdell money?

You owe income tax on the earnings portion of the withdrawal, but not the 10 percent penalty. The scholarship exempts you from the penalty only. Report the withdrawal on Form 1099-Q and calculate the taxable earnings using the IRS worksheet in Publication 970.

What counts as a may have access to education expense for graduate school?

Tuition and fees for graduate or professional school count as may have access to expenses. Books, supplies, equipment, and room and board also count if the student is enrolled at least half-time. The same rules apply to graduate students as to undergraduates, so a Coverdell can be used for law school, medical school, or a master's degree.