Distributions from an Educational Savings Account

DISTRIBUTIONS USED TO PAY QUALIFIED EXPENSES Distributions are generally taxed under rules similar to those for annuities. They are made up of principal (under all circumstances excludable from gross income) and earnings (which may or may not be excludable from income).If the beneficiary uses the entire distributions to pay qualified expenses, the distribution is completely tax exempt. However, when all or part of the distribution is used for other than qualified expenses, then a portion of the earnings is taxable.

Example: The account/or Will Jones contains $10,508 of which $7,000 was from contributions to the account and $3,508 is due to earnings. Will withdraws $6,000 from the account and uses $5,000 for qualified educational expenses and $1,000 for a down payment on a car. Under the annuity rules, 66.62% ($7,000/$ 10,508) of the distribution is treated as principal. This equals $3,997 ($6,000 x .6662). Will can exclude this from his taxable income. The balance, $2,003, must be allocated to earnings and it is potentially taxable to Will depending on his use of the funds. In this case, he used 16.67% ($1,000/$ 6,000) of the distribution for unqualified purposes (the car purchase). Therefore, Will must pay tax on 16.67% of the earnings, $334 ($2,003 x .1667).

DELAYED DISTRIBUTION - Even though contributions to the account are not permitted past the age of 18, the funds can remain in the account and continue to accrue investment earnings up to the mandatory distribution age (prior to age 30). The longer the income accrues tax-free in the account, the greater the benefit derived by the recipient. To maximize the tax-free income, one would want to delay the distribution as long as possible and still be able to utilize all of the funds to pay qualified education expenses. Use the table below to predict IRA growth after the IRA beneficiary turns 18.

DISTRIBUTIONS AT DEATH OF THE BENEFICIARY If the designated beneficiary of an account dies, the account balance must be distributed within 30 days after the death to his/her estate. DISTRIBUTION REQUIREMENTS
WHEN BENEFICIARY REACHES AGE 30 Account funds must be withdrawn or rolled over to another qualified Education IRA before the beneficiary reaches age 30. Distributions that aren’t withdrawn or rolled over are taxable and subject to penalties.Like IRA accounts, the Coverdell Education Savings Accounts can be rolled over once a year and they can be transferred at will for the benefit of the same beneficiary. The rollover must be within 60 days of the original distribution. The accounts can also be rolled or transferred to another qualified member of the taxpayer’s family who meet the age requirements. PENALTIES FOR DISTRIBUTIONS NOT USED FOR EDUCATION A 10% withdrawal penalty applies to the taxable portion of all distributions unless they are:

• Made after death of the designated beneficiary,• Due to the beneficiary's disability, or• Made on account of a tax-free scholarship or other payment to the extent the amount of the distribution isn't more than the amount of the tax-free payment.• Excess contributions (over the annual maximum) and the excess are returned, along with income attributable to it, by the due date of the contributor's income tax return. The net income is included in the distributee's income in the year of the contribution.

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