Education Savings Plans and Qualified Expenses

Posted Jul 28, 2014

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By Patricia M. McCoy, CPA

The popularity of educational savings accounts such as 529 Qualified Tuition Plans (QTPs) and Coverdell Education Savings Accounts (ESAs) continues to grow, and we are taking this opportunity to provide a broad overview of these plans, along with some details of deductions allowed for the distributions. 529 and Coverdell accounts are valuable tax planning tools for ensuring that your loved ones have access to funds set aside specifically for educational purposes. We encourage our clients to consider if these accounts would fit their needs, the needs of their children, or the needs of their grandchildren.

Contributions to Coverdell and 529 plans provide no tax benefit at the time of contribution (similar to a ROTH IRA). However, these accounts continue to grow tax-free over time. Distributions made from these savings accounts for qualified higher education expenses are tax-free.

If you are thinking about contributing to a plan, now may be the time. The state of Arizona provides an Arizona deduction for contributions made to 529 plans (this deduction does not apply to Coverdell accounts). For tax year 2014, the 529 contribution Arizona deduction limit is $2,000 per year if your filing status is single or head of household, and $4,000 per year if you are filing married filing a joint return. Oftentimes, clients think that the plan must be housed in Arizona in order to take the deduction, but that is not the case. Contributions made to any state 529 plan are eligible for the Arizona tax benefit (to the extent that the contributor has Arizona income). Several other states offer tax incentives for funding education. Restrictions and limitations vary by state.

So when it comes time to take the funds out, for what can the distributions be used? Distributions from Coverdell plans (not 529 plans) may be used for qualified K-12 education tuition and fees. There are exceptions for students with special needs. We suggest that you consult your tax advisor if you feel those exceptions may apply. For 529 and Coverdell plans, post-secondary tuition and mandatory fees are considered qualified higher education expenses. If the beneficiary is at least a half-time student at the institution, the amounts paid for room and board are also eligible higher education expenses (not to exceed certain cost-of-living limits set by the educational institution). Computer technology and necessary equipment (e.g. software) also qualify, so long as it can be reasonably proven to be necessary for the student’s attendance.

Take care to keep appropriate records and receipts. For every year that the beneficiary takes distributions, he or she will receive a 1099-Q, which is the form that reports total distributions for the year. In order for the distributions to remain tax-free, the beneficiary must be able to substantiate the claim that the distributions were all for qualified higher education expenses. For example, if certain tools and technology are needed for classes that the student is taking, be sure to keep a copy of the course syllabus to prove its necessity in the event that there is an audit.

Distributions which exceed qualified higher education expenses paid (non-qualified distributions) are subject to income tax on the earnings portion of the distribution. These excess earnings are also typically subject to an additional 10% penalty at the beneficiary’s level.

Please note, the IRS does not allow a double-benefit for qualified tuition and fees. If the beneficiary has qualified tuition and fees which were paid for by 529/ESA distributions, those same tuition and fees cannot be used to also generate an educational credit.

If you have any questions, please contact us and we would be happy to discuss if a 529 plan or Coverdell account would be a good fit for you and your family’s needs.

	529 QTP Plan	Coverdell ESA
Is there an annual contribution limit?	No – however, be mindful of gift tax consequences for contributions in excess of $14,000/year. States impose max 529 account balance limits which vary based on the administering state (2014 AZ 529 max = $396,000 per beneficiary).	Yes – $2,000 max per beneficiary per year (even if the beneficiary has multiple accounts with multiple contributors).
Who can contribute?	Anyone – no income limits.	Individuals/HOH with MAGI <$110,000 andMFJ with MAGI <$220,000.
Must the beneficiary be under age 18 at time of contributions?	No – no beneficiary age limits for contributions to the plan.	Yes – beneficiaries must be under age 18 at time of contributions unless beneficiary is a special needs beneficiary. Account must be fully disbursed by the time the beneficiary reaches age 30.
Can you direct the investment?	No – investments are administered and directed by the state.	Yes – choice to direct is similar to IRA investing.
Can funds be used for grades K-12 education?	No – post-secondary institutions only (this includes 2-year, vocational, and technical post-secondary institutions).