NAFCU Services Blog

Guest post written by Alison Brink, copy writer for the Retirement Services division of Ascensus. Alison researches and writes about various IRA, ESA, and HSA topics for Ascensus’ online and printed publications and education materials.

With students back in school and those glaring tuition bills coming due, many of your Coverdell education savings account (ESA) members may be seeking distributions to help pay (or be reimbursed for) their education expenses. And because a designated beneficiary (the child for whom the ESA is established) does not pay taxes on ESA distributions if the assets are used for qualified education expenses incurred at an eligible education institution, members may have questions about whether their expenses are qualified. While the ESA’s designated beneficiary or responsible individual (often a parent or guardian) ultimately is responsible for determining if education expenses are qualified, they often turn to the ESA administrator with questions.

Eligible Education

ESA assets generally can be used for elementary and secondary education, as well as postsecondary education. Some taxpayers save for postsecondary education through qualified tuition programs, commonly referred to as “529 plans.” But 529 plan assets cannot be used for elementary or secondary education.

Eligible Education Institutions

Part of what makes qualified education expenses qualified is the fact that the expenses have to be incurred at an eligible education institution. 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.

Qualified Education Expenses

Not all education expenses qualify for tax-free ESA distributions. For example, certain computer technology and equipment are qualified elementary and secondary expenses, but not qualified expenses for postsecondary education.

Determining qualified education expenses can be tricky, so taxpayers should be referred to IRS Publication 970, Tax Benefits for Education, or to their competent tax advisor for specific details.

NOTE: A student is considered to be enrolled at least half-time if the student takes at least half of the normal academic workload for the specific course of study. 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.

Contributions made to qualified tuition programs (i.e., 529 plans) also are considered qualified education expenses for ESA distributions. This explains why ESA assets may be transferred to a qualified tuition program.

Nonqualified Expenses

If the ESA assets are not used for qualified education expenses or if the distribution exceeds the total amount of qualified expenses for the year, the assets will be subject to tax on a pro rata basis, taking into account the contributions and earnings in all of the designated beneficiary’s ESAs. An additional 10 percent penalty tax also may apply to the earnings, unless the designated beneficiary qualifies for a penalty tax exception. Penalty tax exceptions may be found in Publication 970 and include:

• A distribution made to a death beneficiary upon the death of the designated beneficiary;

• A distribution made because the designated beneficiary is disabled;

• A distribution included in income because the designated beneficiary received a scholarship or other type of educational assistance (applies only if the distribution does not exceed the scholarship, allowance, or payment);

• A distribution made on account of the designated beneficiary’s attendance at a U.S. military academy (the distribution amount must fall within the allowable limits);

• A distribution included in income because it was taken into account in determining an American opportunity or lifetime learning credit; and

• 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, even though only the responsible individual (who sometimes is the designated beneficiary) can request a distribution. While the distribution is taxable, your organization is not responsible for calculating the taxable portion of the distribution. The IRS provides a worksheet in Publication 970 that taxpayers can use to calculate the taxable amount of an ESA distribution.

Ascensus is the NAFCU Services Preferred Partner for IRA, Retirement Plan, and Health Savings Account (HAS) Solution Software, Training, Documents, and Consulting. More educational content and contact information is available at www.nafcu.org/ascensus/.