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Intro to ESAs
(Coverdell Education Savings Accounts)
Income, estate, and gift tax rules
- Are my contributions to an ESA made with pre-tax or after-tax dollars?
- How are withdrawals taxed?
- What are qualified education expenses? (QHEE)
- What is an eligible educational institution?
- How do we report the withdrawals from the ESA for tax purposes?
- How long does the beneficiary have to use the account?
- What are the exceptions to the additional 10% penalty tax?
- How is my contribution to an ESA treated for gift tax purposes?
- What happens if the beneficiary dies?
- Is there a gift tax consequence if I change the beneficiary on an existing ESA?
Your contributions are made with after-tax dollars, as you are not permitted to claim an income tax deduction for your contributions. This means that any portion of future withdrawals that represent your contributions will come out tax-free even if the earnings portion is taxable.
Your child can receive tax-free withdrawals from a Coverdell ESA in any year to the extent that he or she incurs qualified education expenses (QEE). If your child withdraws more than the amount of QEE, then the earnings portion of that excess is subject to income tax and an additional 10% penalty tax. If you also take withdrawals from a 529 plan in the same year for the same student, you will need to allocate the available QEE between the accounts.
These include qualified higher education expenses and qualified elementary and secondary education expenses (QESEE or "K-12").
QHEE are certain expenses required for your child’s enrollment or attendance at an eligible post-secondary educational institution: tuition, fees, books, supplies and equipment. It also includes a limited amount of room and board if your child is at least a half-time student.
QHEE must be reduced by any other tax-free benefits received, such as scholarships and benefits under a qualifying employer-provided educational assistance program.
QESEE include many of the expenses you might incur in sending your child to grade school, including tuition, fees, books, supplies, equipment, tutoring, and special needs services, as well as the purchase of computer technology used by the student at school or at home. They also include certain items required or provided by the school such as room and board, uniforms, transportation, and supplementary items and services including extended day programs.
This includes any college, university, vocational school, or other post secondary educational institution eligible to participate in student aid programs administered by the Department of Education. You can refer to this list of institutions that have a federal school code, and thus qualify under this definition. For purposes of the K-12 category of expenses, a school is any elementary or secondary school as defined under your relevant state laws, which may include home schools.
In any year in which a withdrawal is taken from the ESA (assuming it is not the correction of an excess contribution), your child will receive a Form 1099-Q and will need to determine how much, if any, of the withdrawal is included in taxable income. The instructions for making this computation are contained in IRS Publication 970. If sufficient qualified education expenses are incurred, then none of the withdrawals are taxable and nothing needs to be reported on Form 1040. If some portion of the withdrawal is taxable, then it must be reported on the Other Income line of Form 1040.
If income is reportable because insufficient qualified education expenses were incurred, then your child is probably also subject to the additional 10% penalty tax. Form 5329 must be filed to compute this tax. The penalty tax can be waived in certain situations (see below).
The ESA must be fully withdrawn by the time the beneficiary reaches age 30. If it is not, the remaining amount will be paid out within 30 days subject to tax on the earnings and the additional 10% penalty tax.
The additional 10% tax will not apply to withdrawals made due to the beneficiary’s death or disability, or to the extent that the beneficiary receives a tax-free scholarship. Also, it will not apply if the withdrawal is taxable only because qualified expenses were adjusted with the Hope, American Opportunity, or Lifetime Learning credit, nor will it apply to a withdrawal that is a return of an excess contribution.
Your contribution is treated as a gift from you to the beneficiary. It qualifies for the $14,000 gift tax annual exclusion. Be sure to keep this in mind if you also contribute to a 529 plan for the same child. You will need to add these contributions together in determining your gift tax filings.
Usually the account value will be paid to the beneficiary’s estate and income tax will be paid on the earnings portion of the distribution. As an alternative, the account beneficiary can be changed to a surviving spouse or other eligible family member without triggering income tax. The value of the account will presumably still be in the estate of the deceased beneficiary, although it will not be "stepped-up" in basis for income tax purposes.
There could be. Although the IRS has not yet issued any regulations, the tax law says that the gift rules should be similar to those for 529 plans. This means that a deemed gift will occur from the old beneficiary to the new beneficiary, but only if the new beneficiary is at least one generation below the old beneficiary. If the amount of the deemed gift excludes the annual gift exclusion amount (currently $14,000), the old beneficiary may make an election to spread the gift ratably over five years for gift-tax purposes.