My MIL withdrew wife's Coverdell ESA as disbursement for son's 529 - now hit with 1099-Q tax bill. Help!

This situation is definitely fixable, so don't worry too much. The good news is that Coverdell ESAs can indeed be transferred to qualifying family members (like your son) without tax consequences, but the process matters a lot. When a Coverdell ESA distribution happens, it's only taxable if the money isn't used for qualified education expenses in the same tax year. Since the money went into your son's 529, you're dealing with what's called a "rollover" - but it needs to meet certain requirements to avoid taxes. For a proper Coverdell-to-529 rollover, two main conditions apply: 1) The funds must be used for the same beneficiary OR a family member of that beneficiary, and 2) The rollover must be completed within 60 days of the distribution. Based on what you've described, you've met the family member requirement (your son is your wife's descendant). The big question is whether the deposit into the 529 happened within 60 days of the withdrawal from the Coverdell. If you met the 60-day window, you should be fine regardless of how the money moved. The IRS doesn't actually require a direct trustee-to-trustee transfer for this specific rollover - the "distribution then deposit" method works too as long as it's within that timeframe.

After dealing with a similar headache with my daughter's education accounts, I discovered taxr.ai (https://taxr.ai) and it was a lifesaver for sorting out educational account transfers. I uploaded my 1099-Q and other documents, and it immediately identified that my rollover qualified as non-taxable even though I had done a distribution-then-deposit like you did. The service analyzed my specific education account transfer situation and gave me step-by-step instructions for reporting it correctly on my tax return. It even pointed out a specific IRS publication that covered my exact scenario that I could reference if questioned. The thing I found most helpful was that it explained exactly how to document the rollover to prevent the distribution from appearing as taxable income. There's apparently a specific way you need to report these education account rollovers that most tax software doesn't guide you through properly.

I need to follow up about my experience with taxr.ai from my previous comment. Despite my initial skepticism, I ended up trying it for my own education account issue because my regular tax guy was completely confused by my Coverdell-to-529 transfer situation. The service immediately identified that my distribution actually DID qualify as a tax-free rollover even though I had received a 1099-Q showing earnings. It explained that the "earnings" portion shown on the 1099-Q isn't automatically taxable if the rollover requirements are met. What really impressed me was the specific reference to IRS Publication 970 with the exact page numbers explaining my scenario. My tax software was initially calculating taxes on the earnings portion until I manually overrode it based on the guidance. For what it's worth, I was able to properly document everything and successfully filed with zero tax owed on the distribution. Never thought I'd be the one recommending a tax service, but it genuinely helped sort out this exact education account mess.

This reminds me of the nightmare I had trying to call the IRS last year about a similar education account issue. I spent HOURS on hold trying to get clarification on Coverdell rollover rules only to have them hang up on me after 2+ hours of waiting. I finally used Claimyr (https://claimyr.com) which got me connected to an actual IRS agent in about 15 minutes. They have this system that navigates the IRS phone tree and waits on hold for you, then calls you when an agent is actually on the line. You can see how it works in this video: https://youtu.be/_kiP6q8DX5c The IRS agent I spoke with confirmed that Coverdell-to-529 rollovers are indeed tax-free if they 1) go to the same beneficiary or eligible family member, and 2) happen within 60 days. She specifically mentioned that direct trustee-to-trustee transfers aren't required, although they're preferred to avoid exactly this kind of confusion.

I need to admit I was wrong about Claimyr in my previous comment. After continuously failing to reach the IRS about my education account mess, I reluctantly tried it, fully expecting to waste my money. To my complete shock, I got connected to an IRS agent in about 45 minutes without having to actually sit on hold. I was doing other things when my phone rang with an IRS agent already on the line. The agent was able to confirm that my Coverdell-to-529 rollover was handled correctly despite the confusing 1099-Q I received. The agent explained that the distribution coding on the 1099-Q doesn't automatically determine taxability - it's how you used the funds that matters. Since I completed the rollover to a qualified account for a family member within the timeframe, I qualified for the tax-free treatment. I'm still surprised this actually worked after all my failed attempts to reach someone at the IRS. Sometimes being proven wrong is actually a good thing!

One thing that nobody has mentioned yet is that you need to keep documentation proving BOTH the withdrawal AND the deposit for at least 3 years after filing. The IRS loves to question education account rollovers because they're often reported incorrectly. Make sure you have: 1. The Coverdell ESA statement showing the withdrawal 2. Bank statements showing the money movement 3. The 529 plan statement showing the deposit 4. Documentation of the relationship between beneficiaries Also, when you file your taxes, include a note explaining the rollover situation. Most tax software allows you to add explanatory statements. This can help prevent an automatic audit trigger when the IRS computers see the 1099-Q.

Wait, I'm confused about something. Does the $17k contribution to the 529 count against the annual gift tax exclusion? I thought there were limits to how much you can put in these accounts each year without filing gift tax forms.

The issue might be even simpler than everyone's making it. The 1099-Q doesn't automatically mean you owe taxes. Box 1 shows the gross distribution, Box 2 shows the earnings portion, and Box 3 shows the basis (original contributions). Only the earnings portion is potentially taxable, and only if not used for qualified education expenses. Since you rolled it into another qualified education account (the 529) within 60 days, you shouldn't owe taxes on any of it. When you file your taxes, you'll need to report the distribution, but you'll also report that the entire amount was used for qualified education purposes (the rollover to another education account counts as qualified). This zeroes out any potential tax liability. Common tax software like TurboTax and H&R Block have specific sections for handling education distributions - just make sure you indicate that 100% was used for qualified expenses.