Navigating Coverdell ESA Distributions
By Ascensus
Coverdell education savings accounts (ESAs) provide a unique savings vehicle with the potential to generate tax-free earnings to cover the costs for education. Tax laws limit ESA contributions to $2,000 per year per ESA owner (i.e., the “designated beneficiary”). ESA assets that are used for qualified education expenses are tax-free. Unlike other education savings tools, ESA assets can be used for elementary and secondary education expenses, as well as postsecondary education expenses.
Financial organizations generally manage their ESA program in a manner similar to their IRA program, but the rules surrounding ESAs differ extensively. With the ability of many platforms to receive contributions electronically, your organization may not hear from your ESA designated beneficiaries or responsible individuals until it’s time for them to take a distribution for qualified education expenses. Here are some common ESA distribution questions that we receive on our consulting lines.
Can the ESA designated beneficiary request a distribution?
This will depend on the facts and circumstances. Only the ESA’s responsible individual can request distributions. Under certain circumstances, the designated beneficiary might 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 the document 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. A financial organization can make a business decision on whether it will do this. However, 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 with his Social Security number, even if a payment is made to an educational facility.
Are distributions not used for education expenses taxable?
ESA distributions are tax-free to the extent the amount of the distribution does not exceed the beneficiary’s qualified education expenses for the year, reduced by any tax-free education assistance she may have received. If a distribution exceeds the beneficiary’s qualified education expenses, a 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, not subject to taxation) 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 into 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 the financial organization do if the ESA designated beneficiary turns age 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.
Is a financial organization required to report basis and earnings on Form 1099-Q?
No. While IRS Form 1099-Q includes boxes in which financial organizations may report the earnings (Box 2) and basis (Box 3) amounts of distributions, this information is optional. Financial organizations that do not report basis and earnings for ESA distributions are required to leave Boxes 2 and 3 blank, and enter the year-end fair market value in Box 7, labeling the amount “FMV” (e.g., “FMV $8,500”).
Are account statements or fair market value statements required for ESAs?
These are no requirements for these reports for ESAs. However, Ascensus recommends that ESA year-end statements be provided to help responsible individuals manage the ESAs. Financial organizations should show the contribution activity for the year and the ESA’s December 31 fair market value. The year-end statement should be provided to the responsible individual (and the designated beneficiary, if necessary) by January 31 to give responsible individuals ample time to make corrections before the tax filing deadline, if necessary.
