683 / How are distributions from an Education Savings Account treated? What are “qualified education expenses”?

Distributions from an ESA are tax-free if they are used solely for the “qualified education expenses” of the designated beneficiary.¹ Qualified education expenses include both “qualified higher education expenses” and “qualified elementary and secondary education expenses.”² Qualified higher education expenses include tuition, fees, costs for books, supplies, and equipment required for the enrollment or attendance of the student at any “eligible educational institution,” and amounts contributed to a qualified tuition program.³ Room and board (up to a certain amount) is also included if the student is enrolled at least half-time.⁴ An “eligible educational institution” is any college, university, vocational school, or other postsecondary educational institution described in section 481 of the Higher Education Act of 1965.⁵ Thus, virtually all accredited public, nonprofit, and proprietary postsecondary institutions are considered eligible educational institutions.⁶

Qualified education expenses are reduced by scholarships, educational assistance provided to the individual, or any payment for such expenses (other than a gift, devise, bequest, or inheritance) excludable from gross income. These expenses are also reduced by the amount of such expenses taken into account in determining the American Opportunity Credit or the Lifetime Learning Credit.⁷

Qualified elementary and secondary education expenses include tuition, fees, and costs for academic tutoring, special needs services, books, supplies, and other equipment incurred in connection with the enrollment or attendance of the designated beneficiary at any public, private, or religious school that provides elementary or secondary education (K through 12) as determined under state law. Also included are expenses for room and board, uniforms, transportation, supplementary items and services (including extended day programs) required or provided by such schools, and any computer technology or certain related equipment used by the beneficiary and the beneficiary’s family during any of the years the beneficiary is in school.⁸

If a designated beneficiary receives distributions from both an ESA and qualified tuition program that in the aggregate amount exceed the “qualified education expenses” of the designated beneficiary, the expenses are allocated among such distributions so as to determine the amount excludable under each.⁹ Any “qualified education expenses” taken into account for purposes of this exclusion may not be taken into account for purposes of any other deductions, credits, or exclusions.¹⁰

Purchase of life insurance with ESA funds is not permitted.¹¹ ESA assets may not be commingled with other property except in a common trust fund or common investment fund.¹² If the beneficiary engages in a prohibited transaction, ESA status is lost and will be treated as distributing all of its assets. If the beneficiary pledges the account as security for a loan, the amount so pledged will be treated as a distribution from the account.¹³

Bankruptcy

Under Section 225 of BAPCPA 2005, funds placed in an “education individual retirement account” (as defined in IRC Section 530(b)(1)) no later than 365 days before the date of the filing of the bankruptcy petition may be excluded from the bankruptcy estate if certain conditions are met.¹⁴