How to Calculate Coverdell ESA Basis

A Coverdell Education Savings Account (ESA) allows taxpayers to establish custodial accounts using post-tax funds. Custodians do not pay income taxes while their accounts grow or earn interest but may pay income taxes upon distribution. Custodians cannot contribute more than $2,000 per year to any individual Coverdell ESA. Generally, the Internal Revenue Service does not tax distributions if they are used for qualified educational expenses. Beneficiaries of Coverdell accounts will pay income taxes if their distributions exceed their annual qualified educational expenses. If you are the beneficiary of a Coverdell ESA, you can find your annual earnings and Coverdell basis by reviewing your 1099-Q form. Your basis is the total amount of your Coverdell contributions minus the amount you withdraw that is not taxable.

Step 1

Review your IRS Form 1099-Q, Payments From Qualified Education Programs (Under Sections 529 and 530). Your bank is legally required to provide you with a copy of the form by Jan. 31, annually.

Step 2

Review Box 3. Box 3 is your basis. Your basis will determine your income tax liabilities each year.

Step 3

Review Box 1. Box 1 reflects the total amount of your annual gross Coverdell ESA distributions.

Step 4

Calculate your income tax liabilities. You will pay taxes on the total amount of your distributions that exceed your qualified educational expenses annually.

Step 5

Use IRS Worksheet 7-3, Coverdell ESA -- Taxable Distributions and Basis. You can find this worksheet at the end of Chapter 7 in IRS Publication 970 (2010), "Tax Benefits for Education." Using the worksheet can reduce the opportunities for making mathematical mistakes in calculating your basis or the difference between your contributions and your qualified tuition expenses.

Tip

Although Coverdell ESAs allow taxpayers to save for educational expenses on a tax-free basis, taxpayers may receive greater tax benefits from 529 savings plans. Similar to Coverdells, 529 accounts grow tax-free. However, there are larger contribution limits for 529 accounts and most states allow you to deduct your contributions on your state income tax returns. On the other hand, although 529 account beneficiaries must use their funds to pay for post-secondary expenses, Coverdell account holders can use their funds to pay for their primary educational expenses in addition to post-secondary educational expenses.

Warning

If you did not report your basis or qualified distributions, you must use the worksheet to calculate your basis, since Box 3 will be empty.

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