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RMDs From Client IRAs: An Unconventional ESA Funding Tool

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For many middle and upper class clients who have planned well, IRA required minimum distributions (RMDs) can actually seem like a burden—increasing tax liability for clients who often do not need the funds to cover living expenses. Despite this, there are ways to make the most of excess RMDs, and funneling these RMDs into an education savings account (ESA) is one recently revived strategy that is often overlooked. 

This strategy may be particularly attractive among well-off clients looking to provide lifetime gifts to children and grandchildren through a tax-preferred vehicle—while simultaneously maximizing their earnings potential through investment options that go above and beyond those available through the more conventional Section 529 plan.

ESA Basics

ESAs were revived by the American Taxpayer Relief Act of 2012, and are essentially accounts established specifically to provide for the qualified primary and secondary education expenses of a designated account beneficiary. The designated beneficiary must be a child who is 18 or younger, though an ESA may be established for an older beneficiary with special needs.

Contributions are limited to $2,000 per year, per beneficiary—but there is no limit on the number of accounts that can be established for multiple beneficiaries. So if the client has multiple grandchildren and would like to fund an account for each, he or she can contribute $2,000 annually for each grandchild’s benefit.

Amounts are deposited into the account on an after-tax basis, but earnings on the deposits will grow tax-free (much like a Roth IRA) and withdrawals are tax-free so long as the funds are used to pay for the beneficiary’s qualified education expenses. 

If the funds are not used to pay for qualified expenses, the distribution will be subject to a 10% penalty tax. Qualified educational expenses include college expenses, but they also include educational expenses incurred for K-12 education, such as tuition or tutoring expenses. 

Generally, all distributions must be made within 30 days of the designated beneficiary’s 30th birthday (or death) unless the beneficiary is a special needs beneficiary.

ESA vs. 529

Many clients may be more familiar with Section 529 education plans, but an ESA does have some important differences to consider. First, an ESA provides special rules for computer expenses for K-12 students so that these expenses are considered qualified expenses if the beneficiary (or his or her family) uses the computer while the beneficiary is in elementary or secondary school.  A 529 plan allows these expenses to qualify only if the beneficiary’s college or university requires the computer.

Further, many clients may be attracted to the increased investment choices offered by an ESA. Often, 529 plans only permit investing in the options offered by the plan itself, while ESAs allow more flexibility for investment in mutual funds and individual stocks. A responsible individual controls the ESA investments (and distributions), and the client may choose to take on that role.

Clients may, however, contribute to both an ESA and a Section 529 plan.

Funding With RMDs

While an ESA is a type of tax-preferred account, the client who uses his or her RMDs to fund the ESA is still required to pay tax on the RMDs at his or her ordinary income tax rates—the transfer is not a tax-free rollover. Therefore, it is important that the client ensure that he or she has sufficient additional funds to satisfy this tax liability when determining ESA contribution levels.

Further, the client will need to ensure that he or she does not exceed the applicable income levels for ESA funding. For many retired clients, these restrictions will not prevent funding, but wealthier clients with income that exceeds $110,000 ($220,000 for joint returns) will not be able to fund an ESA.


An ESA can provide an appealing solution to the “problem” of where to invest excess RMDs—especially for those clients who are looking for another tax-preferred account to help pay for ever-rising educational expenses.

Originally published on Tax Facts Onlinethe premier resource providing practical, actionable and affordable coverage of the taxation of insurance, employee benefits, small business and individuals.    

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For more on college savings strategies, please see:

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