Page 48

toward her $1,000 of qualified education expenses for high school. The qualified expenses are greater than the distribution, making the $800 Coverdell ESA dis- tribution tax free. 2. Next, Beatrice matches her $4,200 QTP distribution to her $3,000 of QHEE, and finds she has an excess QTP distribution of $1,200 ($4,200 QTP − $3,000 QHEE). She can't use the extra $200 of high school expenses (from (1) above) against the QTP distribu- tion because those expenses are not high school tui- tion expenses and don't qualify a QTP for tax-free treatment. 3. Finally, Beatrice figures the taxable and tax-free por- tions of her QTP distribution based on her $3,000 of QHEE. (See Figuring the Taxable Portion of a Distri- bution in chapter 7 for more information.) Example 2. Assume the same facts as in Example 1, except that Beatrice withdrew $1,800 from her Coverdell ESA and $3,200 from her QTP. In this case, she allocates her qualified education expenses as follows. 1. Using the same reasoning as in Example 1, Beatrice matches $1,000 of her Coverdell ESA distribution to her $1,000 of QESEE—she has $800 of her distribu- tion remaining. 2. Because higher education expenses can also qualify a Coverdell ESA distribution for tax-free treatment, Beatrice allocates her $3,000 of QHEE between the remaining $800 Coverdell ESA and the $3,200 QTP distributions ($4,000 total). $3,000 QHEE × $800 ESA distribution $4,000 total distribution = $600 QHEE (ESA) $3,000 QHEE × $3,200 QTP distribution $4,000 total distribution = $2,400 QHEE (QTP) 3. Beatrice then figures the taxable part of the following. a. Coverdell ESA distribution based on qualified edu- cation expenses of $1,600 ($1,000 QESEE + $600 QHEE). See Figuring the Taxable Portion of a Distribution, earlier, in this chapter. b. QTP distribution based on her $2,400 of QHEE (see Figuring the Taxable Portion of a Distribution in chapter 7). The above examples show two types of allocation between distributions from a Coverdell ESA and a QTP. However, you don't have to allocate your expenses in the same way. You can use any reasonable method. Losses on Coverdell ESA Investments For tax years beginning after 2017 and before 2026, if you have a loss on your investment in a Coverdell ESA, you can’t deduct the loss on your income tax return. You have a loss only when all amounts from that account have been TIP distributed and the total distributions are less than your unrecovered basis. Your basis is the total amount of con- tributions to that Coverdell ESA. Additional Tax on Taxable Distributions Generally, if you receive a taxable distribution, you must also pay a 10% additional tax on the amount included in income. Exceptions. The 10% additional tax doesn't apply to the following distributions. 1. Paid to a beneficiary (or to the estate of the designa- ted beneficiary) on or after the death of the designa- ted beneficiary. 2. Made because the designated beneficiary is disabled. A person is considered to be disabled if he or she shows proof that he or she can't do any substantial gainful activity because of his or her physical or men- tal condition. A physician must determine that his or her condition can be expected to result in death or to be of long-continued and indefinite duration. 3. Included in income because the designated benefi- ciary received: a. A tax-free scholarship or fellowship grant (see Tax-Free Scholarships and Fellowship Grants in chapter 1); b. Veterans' educational assistance (see Veterans' Benefits in chapter 1); c. Employer-provided educational assistance (see chapter 10); or d. Any other nontaxable (tax-free) payments (other than gifts or inheritances) received as educational assistance. This exception applies only to the extent the distri- bution isn't more than the scholarship, allowance, or payment. 4. Made on account of the attendance of the designated beneficiary at a U.S. military academy (such as the USMA at West Point). This exception applies only to the extent that the amount of the distribution doesn't exceed the costs of advanced education (as defined in section 2005(d)(3) of title 10 of the U.S. Code) at- tributable to such attendance. 5. Included in income only because the qualified educa- tion expenses were taken into account in determining the American opportunity or lifetime learning credit (see Coordination With American Opportunity and Lifetime Learning Credits, earlier). 6. Made before June 1, 2022, of an excess 2021 contri- bution (and any earnings on it). The distributed earn- ings must be included in gross income for the year in which the excess contribution was made. Page 48 Chapter 6 Coverdell Education Savings Account (ESA)