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in Figuring the Taxable Portion of a Distribution, earlier, figure the taxable portion of your distribution as follows. 1. $850 (distribution) × $1,500 basis + $0 contributions $950 value + $850 distribution = $708 (basis portion of distribution) 2. $850 (distribution) −$708 (basis portion of distribution) = $142 (earnings included in distribution) 3. $142 (earnings) × $700 AQEE $850 distribution = $117 (tax-free earnings) 4. $142 (earnings) −$117 (tax-free earnings) = $25 (taxable earnings) You must include $25 in income as distributed earnings not used for qualified education expenses. Report this amount on Schedule 1 (Form 1040), line 8z, listing the type and amount of income. Worksheet 6-3, at the end of this chapter, can help you figure your adjusted qualified education expenses, how much of your distribution must be included in income, and the remaining basis in your Coverdell ESA(s). Coordination With American Opportunity and Lifetime Learning Credits The American opportunity or lifetime learning credit can be claimed in the same year the beneficiary takes a tax-free distribution from a Coverdell ESA, as long as the same expenses aren't used for both benefits. This means the beneficiary must reduce qualified higher education ex- penses by tax-free educational assistance, and then fur- ther reduce them by any expenses taken into account in determining an American opportunity or lifetime learning credit. Example. Derek Green had $5,800 of qualified higher education expenses for 2021, his first year in college. He paid his college expenses from the following sources. Partial tuition scholarship (tax free) . . . . . . . . . $1,500 Coverdell ESA distribution . . . . . . . . . . . . . . . 1,000 Gift from parents . . . . . . . . . . . . . . . . . . . . . . 2,100 Earnings from part-time job . . . . . . . . . . . . . . . 1,200 Of his $5,800 of qualified higher education expenses, $4,000 was tuition and related expenses that also quali- fied for an American opportunity credit. Derek's parents claimed a $2,500 American opportunity credit (based on $4,000 expenses) on their tax return. Before Derek can determine the taxable portion of his Coverdell ESA distribution, he must reduce his total quali- fied higher education expenses. Total qualified higher education expenses . . . . $5,800 Minus: Tax-free educational assistance . . . . . . − 1,500 Minus: Expenses taken into account in figuring American opportunity credit . . . . . . . − 4,000 Equals: Adjusted qualified higher education expenses (AQHEE) . . . . . . . . . . . . . . . . . . . $ 300 Since the AQHEE ($300) are less than the Coverdell ESA distribution ($1,000), part of the distribution will be taxa- ble. The balance in Derek's account was $1,800 on De- cember 31, 2021. Prior to 2021, $2,100 had been contrib- uted to this account. Contributions for 2021 totaled $400. Using the four steps outlined earlier, Derek figures the tax- able portion of his distribution as shown below. 1. $1,000 (distribution) × $2,100 basis + $400 contributions $1,800 value + $1,000 distribution = $893 (basis portion of distribution) 2. $1,000 (distribution) −$893 (basis portion of distribution) = $107 (earnings included in distribution) 3. $107 (earnings) × $300 AQHEE $1,000 distribution = $32 (tax-free earnings) 4. $107 (earnings) −$32 (tax-free earnings) = $75 (taxable earnings) Derek must include $75 in income (Schedule 1 (Form 1040), line 8z). This is the amount of distributed earnings not used for AQHEE. Coordination With Qualified Tuition Program (QTP) Distributions If a designated beneficiary receives distributions from both a Coverdell ESA and a QTP in the same year, and the total distribution is more than the beneficiary's AQEE, those expenses must be allocated between the distribu- tion from the Coverdell ESA and the distribution from the QTP before figuring how much of each distribution is taxa- ble. The following two examples illustrate possible alloca- tions. Example 1. In 2021, Beatrice graduated from high school and began her first semester of college. That year, she had $1,000 of qualified elementary and secondary education expenses (QESEE) for high school and $3,000 of qualified higher education expenses (QHEE) for col- lege. Her QESEE doesn't include tuition. To pay these ex- penses, Beatrice withdrew $800 from her Coverdell ESA and $4,200 from her QTP. No one claimed Beatrice as a dependent, nor was she eligible for an education credit. She didn't receive any tax-free educational assistance in 2021. Beatrice must allocate her total qualified education expenses between the two distributions. 1. Beatrice knows that tax-free treatment will be availa- ble if she applies her $800 Coverdell ESA distribution Chapter 6 Coverdell Education Savings Account (ESA) Page 47