Coverdell Education Savings Accounts offer tax incentives to save for future costs of school. You can contribute to the account as long as the beneficiary is under 18 years old. However, the tax benefits can last much longer and even be passed down to younger family members if you don't end up needing the money for school.
Any distributions from your Coverdell that you take for qualified educational expenses come out tax-free and penalty-free. Qualified educational expenses include tuition at elementary, high school and post-secondary schools, including trade schools and post-graduate programs. You also can use money from your Coverdell to pay for books, supplies and equipment, tutoring, and a computer and internet access for the beneficiary.
Qualified education expenses include expenses incurred for schooling that starts during the tax year or the first three months of the following year. If your student loans are from costs you paid in prior years, those costs don't count as qualified education expenses for your Coverdell.
Penalties for Non-Qualified Distributions
If you don't use the distributions for qualified educational expenses, you must include the portion of the distribution attributable to earnings as part of your income. For example, say you've contributed $9,000 to your Coverdell and it's now worth $10,000. Ten percent of your account is earnings, so if you take out $1,000, $100 of that distribution is taxable. On top of the income taxes, you also owe a 10 percent penalty unless an exception applies. You can get out of the penalty if you're permanently disabled, are taking out money equal to or less than scholarships you received, or are attending a military academy.
Unlike certain employer-sponsored retirement plans, you aren't allowed to borrow from a Coverdell account.
You must empty your Coverdell before you turn 30 years old. The only exception is if the beneficiary of the account is a special needs beneficiary. There isn't an exception from the non-qualified distribution penalty if you must empty the account because you're turning 30. However, you do have the option to transfer the account to a younger family member, including a sibling, child, niece or nephew, either by changing the beneficiary on your account or by transferring the money into a Coverdell in your family member's name.
You can roll over your money from one Coverdell to another by taking a distribution and then redepositing the money within 60 days.