Going Back to School with an Education Savings Account
By Jennifer Bassett, QKA, CIP, CISP, CHSP
Going back to school usually means spending money—and lots of it. School supplies, tuition, room and board—the list goes on and on. Now may be a good time to remind clients that a Coverdell education savings account (ESA) is an easy, affordable way to begin saving to help pay for education expenses.
Who Can Contribute to an ESA?
Anyone whose modified adjusted gross income falls below or within certain income limits for the year may contribute up to $2,000 per year per child—the ESA designated beneficiary—until the child turns 18 years old (age limit is waived for designated beneficiaries with special needs). The contributions and any subsequent earnings are distributed tax-free when taken to pay for qualified education expenses.
What Are Qualified Education Expenses?
Qualified education expenses are incurred by the designated beneficiary while enrolled at an eligible educational institution. An eligible educational institution generally includes any institution of learning that participates in student aid programs administered by the Department of Education. The following chart lists eligible expenses for higher education, as well as eligible expenses for primary and secondary education. Also noted are the conditions that the expenses must meet to be considered qualified.
What If an ESA Distribution Is Not Used for Qualified Expenses?
If a designated beneficiary or responsible individual making decisions for the beneficiary takes an ESA distribution that exceeds the total amount of qualified education expenses for the same year, the “nonqualifed” portion of the distribution will be taxable pro rata, based on the earnings and basis (the contributions) in the ESA. In addition, a 10 percent penalty tax will apply to the portion representing earnings, unless there’s a penalty tax exception (i.e., death, disability, scholarship and certain other types of educational assistance, attendance at a U.S. military academy, or qualified expenses that were taken into account in determining the American opportunity tax credit (AOTC) or lifetime learning tax credit (LLTC)).
Jessica’s ESA contains $20,000 in assets:
$12,000 represents contributions
$8,000 represents earnings
Her qualified higher education expenses equal $6,500. She withdraws $7,000. The tax and penalty implications of her ESA distribution are:
$6,800 tax- and penalty-free
$200 included in income and subject to additional 10% penalty tax
How Long Can Someone Have an ESA?
Although ESAs are not subject to the “use-it or lose-it” rule, designated beneficiaries cannot keep their ESAs open indefinitely. Within 30 days after attaining age 30, designated beneficiaries must either distribute their ESA assets (if not, they will be “deemed” distributed for tax purposes), or transfer or roll over the ESA assets to a qualified family member’s ESA. Eligible family members include the designated beneficiary’s
child or descendent of the child, stepchild, or eligible foster child;
brother, sister, stepbrother, or stepsister;
father, mother, stepfather, or stepmother;
aunt or uncle;
niece or nephew;
son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, or sister-in-law;
a spouse of any of the individuals named above; or
a first cousin.
The age 30 limit does not apply to designated beneficiaries with special needs.
Are ESAs Portable?
It should be noted that ESAs are portable; they can be rolled over to state-sponsored higher education savings plans, also known as qualified tuition programs (QTPs) or 529 plans. This makes an ESA even more practical, as the benefits accrued in an ESA need not be lost if the QTP or 529 plan is later found to be a more advantageous saving option.
Spread the Word
While you don’t want to give clients tax advice, you should provide information on the different ways they can save for education expenses. You can refer clients to external sources, such as IRS Publication 970, Tax Benefits for Education, or provide them with your own internal information, such as a consumer education brochure. This can create new business opportunities for your organization and provide a valuable service to your clients.