What Does It Mean to Have a Nonqualified ESA Distribution?
By Shelly McKinnon, QKA, CRSP, CIP, CHSP
What is the difference between a qualified and a nonqualified distribution from a Coverdell education savings account (ESA)?
A qualified distribution is any distribution taken from an ESA to pay for the designated beneficiary’s qualified education expenses. Qualified distributions are tax-free to the extent that the distribution amount does not exceed the beneficiary’s qualified education expenses.
A nonqualified distribution is any distribution that exceeds the qualified education expenses for the year or that is taken to pay for a nonqualified expense. ESA distributions that are not used to pay for qualified education expenses are taxable on a pro-rata basis, taking into account the earnings and basis (contributions) in all of the designated beneficiary’s ESAs. While the financial organization is not responsible for calculating the taxable and nontaxable portions of the distribution, the financial organization is responsible for reporting the distributions to the designated beneficiary.
Does a penalty tax apply to nonqualified ESA distributions?
An additional 10 percent tax may apply to the earnings portion of a nonqualified distribution, unless the designated beneficiary qualifies for an exception. Exceptions include the following.
A distribution made to a death beneficiary upon the designated beneficiary’s death
A distribution made because the designated beneficiary is disabled
A distribution included in income because the designated beneficiary received a scholarship or other type of education assistance
A distribution made on account of the designated beneficiary’s attendance at a U.S. military academy (within the allowable limits)
A distribution included in income because it was taken into account in determining an American opportunity or lifetime learning tax credit for the same year
The removal of an excess contribution before June 1 of the year following the year for which the excess contribution was made
The designated beneficiary would file IRS Form 5329, Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts, to claim a penalty exception.
How long can a designated beneficiary maintain an ESA?
Assets remaining in the ESA when the designated beneficiary reaches age 30 must be distributed within 30 days after the designated beneficiary’s 30th birthday. As an alternative, the remaining assets may be transferred or rolled over to an ESA for a qualified family member who is under age 30.