Education Savings Account: Avoiding Taxes On Distributions
  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

Education Savings Account: Avoiding Taxes On Distributions

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

  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
  1. Form 1099-Q

    An IRS form that an individual who receives distributions from ...
  2. IRS Publication 972: Child Tax Credit

    A document published by the Internal Revenue Service (IRS) that ...
  3. Hardship Withdrawal

    An emergency withdrawal from a retirement plan that may be subject ...
  4. American Opportunity Tax Credit

    A tax credit that enabled more student and parents to pay for ...
  5. Additional Child Tax Credit

    A refundable credit that can be claimed by taxpayers who are ...
  6. Net Of Tax

    An accounting figure that has been adjusted for the effects of ...
  1. What options do I have to save for my child's education?

    There are numerous options available to invest savings for a child's education: State-sponsored "529" college savings plans: ... Read Answer >>
  2. Can my IRA be used for college tuition?

    Find out how to use your IRA retirement savings to pay for your college tuition, including what institutions and expenses ... Read Answer >>
  3. What are the risks involved in a banker's acceptance?

    Learn about the different kinds of college savings accounts, how they can benefit a college saver and how to open these savings ... Read Answer >>
  4. Can I use my IRA to pay for my college loans?

    Learn about how to use your IRA retirement savings to pay for your college loans, including how to avoid the 10% early withdrawal ... Read Answer >>
  5. Can I take money out of my Individual Retirement Account (IRA) while working?

    Can I take money out of my IRA plan if I'm still working? Yes, you can take money out of your IRA plan if you’re ... Read Answer >>
  6. What is the difference between a write-off and a deduction?

    Understand the differences between a tax write-off and a tax deduction. Learn how each one works to reduce income taxes and ... Read Answer >>
Trading Center