Distributions from a Coverdell ESA can be rolled over to another Coverdell ESA, either for the same beneficiary or for a member of the beneficiary’s family (including the beneficiary’s spouse) under 30 years of age. If the rollover is done within 60 days, the distribution will not be taxable.
Instead of taking a distribution and rolling it over to another Coverdell ESA, the designated beneficiary can transfer the balance to a family member by instructing the trustee to change the name of the designated beneficiary on the account. This does not generate any tax consequences, provided the new beneficiary is under age 30.
Distributions
The designated beneficiary of a Coverdell ESA can withdraw funds at any time. Whether the distribution is taxable will depend on whether the distributions during a year are equal to or less than the amount of qualified education expenses the beneficiary has during the year, reduced by any tax-free educational assistance, including:
the tax-free part of scholarships or fellowships,
veterans’ educational assistance,
Pell grants,
employer-provided educational assistance.
The amount determined by subtracting any tax-free educational assistance from qualified education expenses is referred to as “adjusted qualified education expenses”.
Tax-Free Distributions
If the amount withdrawn from a Coverdell ESA (the distribution) is less than adjusted qualified education expenses, the distribution is tax-free.
Taxable Distributions
If the amount withdrawn from a Coverdell ESA is more than adjusted qualified education expenses, the excess portion of the distribution is partially taxable. The part that is taxable is the portion of the distribution that represents earnings that have accumulated tax-free in the account.
Part of the distribution represents a return of your basis – contributions that have been made to the Coverdell ESA. Since these contributions were not deductible when made, they are not taxed when distributed. Assuming you paid adjusted qualified education expenses with the amount you withdraw, part of the accumulated earnings would also be tax-free:
tax-free earnings equals
amount of the distribution
minus the part that represents a recovery of your basis
equals the portion of the distribution that represents accumulated earnings.
The above amount (earnings)
times the proportion of your adjusted qualified education expenses / your distribution
equals tax-free earnings.
It then follows that total earnings minus tax-free earnings equals taxable earnings. This taxable part would be reported as Other Income on Form 1040.
There is a worksheet entitled “Coverdell ESA – Taxable Distribution and Basis” in IRS Publication 970, Tax Benefits for Education, that will take you through the exercise described above.