Answers to 5 Common ESA Distribution Questions
As a new school year begins, your organization may notice an uptick in questions from clients about distributions from Coverdell education savings accounts (ESAs). Here are the answers to five of the more common questions you may hear.
Can the ESA designated beneficiary request a distribution?
Whether a designated beneficiary—the child for whom the ESA is set up for—can request a distribution will depend on facts and circumstances. Only the ESA’s responsible individual can request distributions. Under certain circumstances, however, the designated beneficiary may become the responsible individual, and if so, could request a distribution. An election in the ESA application or plan agreement may allow the designated beneficiary to become the responsible individual upon reaching the age of majority. Financial organizations should review their ESA documents to make this determination. Note that the rules concerning age of majority and emancipation may differ from state to state.
Can a financial organization make an ESA payment directly to an education facility instead of to the designated beneficiary?
ESA responsible individuals sometimes ask financial organizations to pay the education expense directly, rather than making the payment to the designated beneficiary. For example, a parent whose child is some distance away at a college may ask the financial organization to send a check directly to the college to pay the child’s tuition. Financial organizations can make a business decision on whether to do this. Regardless, all withdrawals from an ESA must be reported on Form 1099-Q, Payments From Qualified Education Programs (Under Sections 529 and 530), as a distribution to the designated beneficiary, in his name and Social Security number, even if a payment is made directly to an educational facility.
Are distributions that are not used for education expenses taxable?
ESA distributions are tax-free to the extent that the amount of the distribution does not exceed the beneficiary’s qualified education expenses, reduced by any tax-free education assistance she may have received. If a distribution exceeds the beneficiary’s qualified education expenses, the portion of the distribution in excess of qualified expenses is taxable to the beneficiary. The amount exceeding qualified expenses is taxable pro rata, based on the amount of basis (ESA contributions) and earnings in the account. In most cases, the taxable portion is also subject to an additional 10 percent penalty tax, but there are some exceptions. See Publication 970, Tax Benefits for Education, for details.
If the distributed amount is more than the qualified education expenses for the year, can the overage be put back into the ESA?
If the error is discovered early, the distributed assets could be rolled back over to an ESA if the designated beneficiary is otherwise eligible for a rollover. The amount must be rolled back into an ESA within 60 days after the date of the distribution. But each designated beneficiary can roll over only one ESA distribution in any 12-month period. Otherwise, there are no rules that would allow mistaken distributions to be returned to the ESA.
What should a financial organization do if the ESA designated beneficiary turns 30 and the responsible individual has not requested the ESA balance to be distributed?
The law requires that any assets remaining in the ESA must be distributed within 30 days after the designated beneficiary turns age 30, unless it is a special needs designated beneficiary. As an alternative, the responsible individual may request that the ESA assets be transferred or rolled over to an ESA for a qualified family member who is under age 30.
Most ESA plan agreements allow financial organizations to distribute the remaining balance within 30 days of the designated beneficiary’s 30th birthday. An attempt to contact the responsible individual also could be made.
