Let's say you've been a smart parent when it comes to saving for your child's education expenses by setting up a tax-advantaged education savings accounts, either a popular 529 college savings plan or the lesser known Education Savings Account (ESA).
But when it comes time to start paying those expenses, you need to know the rules for taking withdrawals and avoiding taxes. After all, the whole point is that money saved in these accounts is tax-free when withdrawn for certain education expenses, known as a Qualified Education Expense, or QEE, as specified in IRS Publication 970.
It's important to note that the rules differ for ESAs and 529 plans. Unlike 529s, tax-free withdrawals from ESAs for qualified expenses aren't limited to college or other postsecondary programs. Costs for elementary or high school education also qualify.
Another difference: 529 plans have no deadline or age at which money must be distributed. But money in an ESA must be distributed before the account beneficiary reaches age 30. If not, the portion of the balance representing earnings will be taxed as income and subject to an additional 10 percent penalty tax.
For these reasons, parents who have money in both an ESA and a 529 plan should withdraw from an ESA first.
Tax-free ESA withdrawals can be made for a beneficiary's costs for tuition and fees, room and board as required by a school, academic tutoring and even computers and Internet costs. Also, when required by the school, the costs related to transportation, uniforms and services are eligible.
Tax-free distributions from 529 accounts can also pay for qualified higher education expenses, or QHEE. These include tuition, fees, books, supplies, equipment and the additional expenses of a "special needs" beneficiary. For students who are pursuing a degree on at least a half-time basis, this also includes a specified amount of room and board.
Here are some commonly incurred expenses that don't qualify:
- Insurance, sports or club activity fees, and many other types of fees that may be charged but aren't required as a condition of enrollment.
- A computer, unless the institution requires that students have their own.
- General transportation costs.
- Repayment of student loans.
- Room and board costs in excess of the amount the school includes in its "cost of attendance" figures for federal financial aid purposes.
If the student is living in a school-owned dormitory, you can withdraw the amount the school charges for room and board. If the student is living off campus, ask the financial aid department for the room and board allowance for students living at home or elsewhere off campus.
You'll also have to consider the coordination rules for taking tax-free education account withdrawals and claiming education tax credits. You can't declare educations costs for either the American Opportunity tax credit or the Lifetime Learning credit and also take tax-free withdrawals from a 529 or ESA. Because the tax credits are more valuable and apply to the first $4,000 of education expenses, you should use those first, then pay for remaining expenses with education account withdrawals.
Finally, if you do withdraw more than the amount that covers qualifying education costs, and it's less than 60 days since the withdrawal, you can deposit the excess amount into another 529 account, and it will no longer be treated as a taxable distribution.
Otherwise, the excess withdrawal is a nonqualified distribution. You or your beneficiary (you get to choose who receives the money) will have to report taxable income and pay a 10 percent penalty tax, but only on the earnings portion of the nonqualified distribution.