Coverdell Education Savings Accounts are tax-advantaged trust arrangements used to pay for qualified education costs. Contributions to an ESA can be made by anyone who meets Internal Revenue Service income requirements until the beneficiary is age 18, as long as the total of all contributions doesn’t exceed $2,000 in a year. ESA contributions are not tax-deductible. Withdrawals that aren’t used for qualified expenses may be subject to taxes and penalties.

How Coverdell ESAs Work

All you have to do to avoid penalties on a Coverdell ESA withdrawal is to withdraw no more than the qualified education expenses you pay each year. In fact, money you take out of an ESA for qualified expenses is tax-free. Qualified expenses are those costs necessary for enrollment and attendance at a college or technical school. You can also use ESA funds to cover costs for an accredited primary or secondary school. Fees, tuition, books, equipment and supplies are all qualified expenses. Room and board can also be qualified if necessary for attending the school.

Penalty for Non-Qualified Distributions

According to the IRS, when you withdraw more than the amount of qualified education expenses, the excess is taxable income for the student who is the beneficiary of the ESA. This means that you pay income taxes on the extra money, and you may have to pay a 10-percent penalty tax as well. When you calculate how much to withdraw, subtract from your total qualified education expenses any amount covered by scholarships or grants, and the amount of a Lifetime Learning or American Opportunity tax credit. Use ESA funds only for what’s left over and there will be no penalty.

Penalty Exceptions

The IRS waives the 10-percent penalty in the event that a beneficiary becomes disabled or passes away. The IRS will also skip the penalty when a beneficiary receives a scholarship. Suppose you withdraw $2,000 to pay qualified education expenses one semester, and then you get a scholarship to cover the $2,000 that you didn’t expect. In this situation, you would not owe the penalty, although you’d still have to pay income taxes on the money taken from the ESA.

Taxation of Leftover ESA Money

A student who is the beneficiary of an ESA has until age 30 to use all of the money. Any funds that remain in the account at that time become subject to income taxes and the 10-percent penalty tax. This age limit does not apply for special-needs students. The IRS provides a way to avoid paying these taxes: You can roll the undistributed funds over to the ESA of a sibling or other family member who is under the age of 18.