Educational Savings Account

Why Establish an Education Savings Account?

With the increasing costs of education, it is only practical that individuals save for those future student years. One of the means of saving for these years is the education savings account (ESA). The assets contributed to an ESA accumulate earnings tax deferred, and distributions used for qualified education expenses incurred at elementary, secondary and post-secondary educational institutions are tax and penalty free.

Contributions are discretionary, which means that the contributor/s are not required to make deposits to the account every year.

Eligibility
There are several parties involved in the establishment and administration of an education savings account(ESA). Each party's role is defined by regulations and the ESA plan document. These parties are the following:

In the list above, the responsible individual is usually the designated beneficiary's parent or legal guardian. The designated beneficiary, however, becomes the responsible individual upon reaching the age of majority as determined by his or her state of residence. Only one person may serve as the responsible individual at any given time.

The death designated beneficiary must not be more than 30 years old and must assume ownership of the assets within 30 days after the death of the designated beneficiary.

Who Can Establish and Contribute to an Education Savings Account?
Anyone who meets the compensation requirements (which we discuss below) can establish and contribute to an ESA. This means that the beneficiary can establish an ESA for him- or herself.

Corporations, tax-exempt organizations and other non-person entities are allowed to contribute to an ESA on behalf of a beneficiary. The income limitations that apply to individuals do not apply to these entities.

Compensation Requirements
To be eligible to contribute to an ESA, the contributor's modified adjusted gross income (MAGI) shown on his or her income tax return must not be more than $110,000 for single filers and $220,000 for married individuals filing joint returns.

Individuals whose MAGI falls between the following ranges are able to make a partial contribution, which will be an amount less than the contribution limit of $2,000 per year:

No Compensation Required
While an individual whose income exceeds the limits stated above is not eligible to contribute to an ESA, an individual is not required to have compensation to be eligible to contribute to an ESA. This is unlike the rules for a Traditional or Roth IRA, which both require an individual to have eligible compensation to contribute.

Age Requirements For Contributions
Contributions can be made to an ESA for any individual who is under age 18, but an ESA cannot be established for an unborn child.

Age Requirements For For Distributions
The balance in the account generally must be distributed within 30 days after the earlier of the following events:

These age limitations are waived for special-needs beneficiaries - individuals who, because of a physical, mental or emotional condition (including a demonstrable learning disability), require additional time to complete their education.

Change in the Designated Beneficiary
The designated beneficiary may be changed to a qualified family member who has not attained age 30 if the original designated beneficiary dies or has no qualified education expenses (which we define in the section on distributions). The designated beneficiary may also be changed from one spouse or former spouse to another in accordance with a court-approved divorce decree.

Education Savings Account: Contributions
Regular contributions to ESAs must be made in cash. Transfers and rollovers of assets from other ESAs may be made in the form of securities and other non-cash items. The responsible individual (the role of whom is explained in the section on eligibility, however, should check with the ESA custodian/trustee to determine permissible investments for the ESA.

Contribution Limit
The maximum amount that may be contributed on behalf of any designated beneficiary is $2,000 per year. This is true regardless of the amount of ESAs maintained by the beneficiary.

If an eligible individual contributes to more than one ESA, he or she may contribute up to his or her maximum limit for each beneficiary's account. For example, say an individual has a modified adjusted gross income (MAGI) of $50,000, and has two children under age 18. That individual can contribute a maximum of $2,000 to each child's ESA.

Phase-out Ranges
As we stated in the section of eligibility, individuals whose MAGI falls between the following phase-out ranges are able to make a partial contribution (an amount less than the contribution limit of $2,000):

Contribution Deadline
Like IRA contributions, ESA contributions must be made by the tax-filing deadline (not including extensions) of the designated beneficiary. This is usually Apr 15 following the tax year.

Permissible Investments in ESAs
One benefit of investing in an ESA is that the investment options are many and varied. There are relatively few investments that are not permitted in an ESA, but whether the responsible individual (the person who manages the ESA) can choose the investments depends on the financial institution. Some accounts may be limited to a pre-selected core group of investments or a specific investment while other accounts allow the responsible individual to choose the investments.

Permissible investments for ESAs include stocks, bonds, mutual funds, real estate, some coins and money market funds.

Investments in Collectibles
ESAs cannot contain investments in collectibles, which include: art works, rugs, antiques, metals, gems, stamps, coins, alcoholic beverages and other types of tangible personal property.

The exception to the rule is that ESAs can have investments in U.S. gold coins, silver coins minted by the U.S. Treasury, certain forms of platinum, gold, silver, palladium and platinum bullion. Volume limitations apply.

Some financial institutions place further restrictions on ESA investments.

Education Savings Account: Distributions
Distributions from an ESA are pro-rated between contributions and earnings. That means a distribution will come from either the portion of the ESA that represents contributions or the portion that represents earnings.

Distributions from ESAs that are used for qualified education expenses are tax and penalty free. A distribution that is not used for qualified education expenses (defined below) is subject to tax and an additional 10% early-distribution penalty if the distribution is taken from the ESA's earnings. A distribution of contributions, however, is always tax and penalty free because no tax deductions are allowed for amounts when they are contributed to the ESA.

Qualified Education Expenses
Generally, qualified education expenses are those required for the designated beneficiary's enrollment or attendance at an eligible school. These include certain higher-education expenses and certain expenses for education at elementary and secondary schools. Eligible schools include all public, private or religious schools that provide elementary or secondary education (kindergarten through grade 12) as determined under state law.

Qualified education expenses for ESA distributions include:

Tax Treatment of Distributions
As stated above, a distribution from an ESA that is not used for qualified educational expenses may be subjected to income tax and an additional 10% early-distribution penalty. The tax and penalty applies only to the earnings portion of the distribution. The 10% early-distribution penalty will be waived if the distribution occurs for any of the following reasons:

Education Savings Account: Conclusion
Similar to the 529 plan, the Education Savings Account (ESA) is an excellent means of savings for education expenses.

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