1. Education Savings Account: Introduction
  2. Education Savings Account: Qualifying To Contribute
  3. Education Savings Account: Opening An ESA
  4. Education Savings Account: Avoiding Taxes On Distributions
  5. Education Savings Account: Conclusion

By Reyna Gobel

ESAs are technically considered tax-advantaged accounts. If your child pays any tax on earnings or contributions, it's because you've disobeyed the ESA rules.

We'll look at the actions that trigger tax penalties and how you can avoid breaking the rules.

Non-Education Withdrawals
If the beneficiary withdraws money for non-education expenses, there is a hefty penalty for withdrawal. The penalty tax is 10% of the taxable amount, and your child will have to pay income tax on the earnings. To ensure your child won't be taxed, follow these steps.

1. Pick a school that qualifies.

  • School eligibility for post-secondary training programs, including college, is any school that's eligible for federal financial aid.
  • School eligibility for elementary and high school students is any institution that meets state requirements.
2. Use the money in your account only for these expenses based on information from IRS Publication 970

Qualifying Education Expenses
Elementary or High School Education
College or other Postsecondary Programs
Tuition and fees
Tuition and fees
Books, supplies or equipment
Books, supplies or equipment
Special needs services
Special needs services (only if required to complete course of study)
Room and board if required or offered by school
Room and board to the extent that:
a) The total amount is less than the estimated housing cost according to financial aid.
b) The total amount is less than the price of school owned or operated housing
*Coverdell Education Savings Account Funds can only be used for room and board if the beneficiary is at least a half-time student.
Academic tutoring

If required or offered by the school: transportation, uniforms and services offered to supplement schooling with the exception of extended day programs.

Computers and internet usage is allowed, too, if used solely for educational purposes.



ESA Tax Rules
There are two situations that will result in getting taxed on the money earned and also on deposited funds:

1. Waiting Too Long
The beneficiary needs to withdraw his or her money on time. According to the IRS, if there is a balance in the ESA when the beneficiary reaches age 30, it must be distributed within 30 days. A portion representing earnings on the account will be taxable and subject to the additional 10% tax. The beneficiary may avoid these taxes by rolling over the full balance to another Coverdell ESA for another family member.

How high could a penalty climb? Let's say Julie accumulated $2,000 in deposits per year until her 18th birthday. She has $36,000 of pre-profit or interest earnings. She earned $18,000 from this investment. She started off her 18th year with $52,000 in the bank. This is partially due to the fact that her parents and grandparents put the money into the account for her college education. She never went to private school in her pre-college years. (Some savings vehicles may be better than college saving funds for some families. Read Pay For A College Education With Retirement Funds.)

Julie won a full-ride scholarship and didn't need much monetary help to attend college. She only spent money from her ESA for textbooks. She used a total of $2,000 of her contributions. Her investment earned another $30,000 by the time she turned 30. With $48,000 in earnings and $34,000 in contributions, she would be taxed on the earnings and 10% early distribution penalty as well which would amount to $4,800. While this seems like a lot of money, she still has $77,200, less any income tax owed on the earnings. She could transfer her ESA to a beneficiary, a younger sibling or spouse, to avoid taxes. However, she would no longer have the money.

Putting In Too Much
There are also problems if the child's combined contributions go over $2,000 in a given year. All contributions combining for the benefit of a particular child over $2,000 for a taxable year will be treated as excess contributions. There will be a 6% excise tax if the excess contributions and earnings on them are not withdrawn from the child's account(s) before June 1 of the following tax year. The tax will be levied for each year the excess amount remains in the account.

For example, Toby was lucky enough to receive $4,600 in contributions in his ESA from various relatives this past year. If he doesn't withdraw the extra $2,600 out of his account for educational expenses by June 1 of the next tax year, he will owe 6% of $2,600 plus 6% of any interest or profits derived from the $2,600 invested. On the excess contributions alone, that's $156. If Toby keeps the $2,600 in his account for future years, he will owe another $156 per year until the excess contributions are withdrawn.

Parting Tax Tips
Your child can avoid most tax penalties by using the ESA for qualified education expenses. However, there may be circumstances like a full-ride scholarship that can't and shouldn't be avoided. In this case, taxes will be charged, but this still leaves a hefty payout for your child when he or she turns 30. Education Savings Account: Conclusion

Related Articles
  1. Personal Finance

    Education Savings Account Tutorial

    This comprehensive guide goes through what an Education Savings Plan is and how to set one up, contribute to it and withdraw from it.
  2. Investing

    Education Savings Account: Opening An ESA

    By Reyna Gobel Once you know you can contribute to an account, you can open an ESA at pretty much any bank, credit union, mutual fund company, or brokerage firm. The question is when a whole ...
  3. Retirement

    Don't Forget The Kids: Save For Their Education And Retirement

    Retirement and education financing are the two most important planning items for taxpayers.
  4. Investing

    Education Savings Account: Conclusion

    By Reyna Gobel Recap: Anyone can contribute to an ESA on behalf of a child. ESAs must be started and funded before age 18, but after a child is born. Co-ordinate with other contributors ...
  5. Personal Finance

    Why Coverdell ESAs May Trump 529 Plans

    Coverdell ESAs still trail 529 plans in popularity by a wide margin due to their low contribution limits. But these accounts can be a viable alternative.
  6. Personal Finance

    Tax-Smart Ways To Help Your Kids/Grandkids Pay For College

    Learn about plans and accounts that allow you to efficiently save for your child or grandchild’s education while shielding the savings from the IRS as much as possible.
  7. Personal Finance

    Investing In Your Child's Education

    Overwhelmed by increasing tuition costs for your kids? The U.S. government can help.
  8. Personal Finance

    Spoil Your Grandkids, Cut Your Tax Bill

    Helping your grandchildren save for college is a way to spoil them and reap some benefits yourself.
  9. Retirement

    Retirement Plan Tax Form 5329: When To File

    Read this if you've taken early distributions or owe excess-contribution or excess-accumulation penalties.
  10. Personal Finance

    529 Plans: Introduction

    By Denise Appleby 529 plans (also known as a "qualified tuition program") were created under the Small Business Job Protection Act of 1996 (SBA '96) as a means of allowing taxpayers to save ...
Trading Center