Q is for Qualified Coverdell ESA Distributions: Helping Your Clients Pay for Education Expenses
The school year is back in full swing and for college and private school students, that means their tuition bills are due. They, along with their parents, might be calling or stopping by your branch office seeking Coverdell educational savings account (ESA) distributions to help pay (or get reimbursed for) their education expenses.
If it’s been a while since you’ve worked with ESAs, here’s a refresher on the rules and your responsibilities when processing ESA distributions.
A designated beneficiary is the child or young adult for whom the ESA was established. A designated beneficiary doesn’t pay taxes on ESA distributions if the money is used for qualified education expenses incurred at an eligible educational institution. The responsible individual (often the designated beneficiary’s parent) or the designated beneficiary must determine if the education expenses are qualified, but they may ask questions about the process of using the ESA assets.
What is an Eligible Educational Institution?
ESA assets aren’t just for paying college expenses. These accounts can be used to pay for elementary and secondary education, as well as postsecondary education. An eligible elementary or secondary school for ESA purposes is any public, private, or religious school that provides elementary and secondary education (kindergarten through grade 12) as determined under state law. An eligible postsecondary school is any college, university, vocational school, or other postsecondary educational institution that is eligible to participate in student aid programs administered by the Department of Education. An eligible educational institution would include nearly all accredited public, nonprofit, and private postsecondary institutions.
What are Qualified Education Expenses?
Not all educational expenses are considered qualified for ESA distribution purposes. For example, academic tutoring is a qualified elementary and secondary expense, but not for postsecondary education. Room and board expenses can be considered a qualified education expense, but the amount that is considered “reasonable” is defined by the specific educational institution. A student is considered to be enrolled at least half-time if the student takes at least half of the normal academic workload for their specific field of study. The definition of “half-time workload” is determined by the educational institution where the student is enrolled, but the institution’s standard for full-time workloads must equal or exceed the standards established by the Department of Education.
If the withdrawn ESA assets exceed the qualified higher education expenses for the year, the portion of the distribution that exceeds expenses is taxable. The taxable portion is the amount of the excess distribution that represents earnings; the basis portion (contributions) of the excess is not taxable. The taxable portion of the distribution also is subject to a 10 percent penalty tax, unless the designated beneficiary qualifies for one of the following penalty tax exceptions.
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 tax-free scholarship or fellowship grant,
veterans’ educational assistance,
employer-provided educational assistance, or
nontaxable payments received as educational 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 credit.
The removal of an excess contribution before June 1 of the year following the year for which the contribution was made.
All nonqualified distributions are taxable to the designated beneficiary. Your financial organization is not responsible for calculating the taxable portion of a nonqualified distribution. The IRS provides a worksheet in Publication 970, Tax Benefits for Education, that can be used by taxpayers use to calculate the taxable amount of an ESA distribution.
If your clients are unsure whether certain education expenses are qualified, refer them to IRS Publication 970, or to a competent tax advisor.
How to Process an ESA Distribution
The ESA’s responsible individual must generally authorize any transactions. The responsible individual is usually the designated beneficiary’s parent or legal guardian. But under certain circumstances, an election in the ESA plan agreement may allow the designated beneficiary to become the responsible individual upon reaching the age of majority.
The responsible individual should complete an ESA withdrawal form. You’ll then provide a copy of the withdrawal form to both the responsible individual and to the designated beneficiary (or guardian), retaining all documentation so that you can report the distribution on Form 1099-Q, Payments From Qualified Education Programs (Under Sections 529 and 530).
Here are the reporting requirements for Form 1099-Q.
Box 1 – Enter the gross distribution amount.
Box 2 – Enter the earnings portion of the amount in Box 1 (optional unless reporting net income attributable for excess contributions).
Box 3 – Enter the basis portion of the amount in Box 1 (optional).
Box 4 – Check this box if the amount in Box 1 was from one ESA to another ESA at different financial organizations or to a QTP.
Box 5 – Check the Coverdell ESA box to indicate reporting for an ESA.
Box 6 – Check this box if the distribution recipient is not the ESA’s designated beneficiary (e.g., a death beneficiary).
If your financial organization cannot separately report the earnings from basis, you may leave Boxes 2 and 3 blank, according to the Form 1099-Q instructions. However, if you do this, you must enter the fair market value at the end of the tax year in the blank box below Boxes 5 and 6 and label the amount “FMV.” For example, a $6,000 FMV may be entered as “FMV 6,000.”
