ESA Beneficiaries

As you may have predicted, there are rules that govern who is eligible to be the beneficiary of a Coverdell Education Savings Account (ESA).

An ESA has to be opened before the beneficiary of the ESA is 18 years of age. There's no age minimum--an ESA can be opened on the day the beneficiary is born. Once the beneficiary reaches age 18, no more contributions can be made to the ESA set up for them. There is an exception to the age rule for beneficiaries with special needs.

Mandatory distributions. If the beneficiary of an ESA turns 30 and there's still a balance in the ESA, the balance has to be distributed within 30 days. Of course, the money distributed is no longer tax-free unless it is used to pay qualified educational expenses. The beneficiary has to pay ordinary income tax and a 10 percent penalty to boot on the distribution. The age limit is waived for beneficiaries with special needs, (physical, mental or emotional conditions, including learning disabilities).

Beneficiary/family relationships. You may be wondering what the beneficiary's relationship must be to the person or persons making the contributions to the ESA. The answer is that no relationship between the contributor and the beneficiary is necessary. They do not have to be parent and child, or grandparents and grandchild, although this is certainly the most common scenario. Remember, the contributor isn't getting a tax deduction for putting money into the ESA, so there must be a different incentive, and that incentive usually is investing for the education of a child or grandchild.

There is one situation where the family relationship does matter in regards to ESAs, and that is if the beneficiary wants to transfer his or her ESA to someone else. An ESA's assets can be transferred from one ESA to another. An ESA's beneficiary may also be substituted with a new beneficiary from the current beneficiary's family. The family member must be a spouse, child, grandchild, parent, grandparent, sibling, aunt, uncle, or cousin. Some in-laws qualify as well. The new beneficiary must also be under 30 years old.

On that note, situations can arise that make the ability to change the beneficiary of an ESA very important.

Example Tom and Doug are brothers. Tom is 19 years old and Doug is 17 years old. Both Tom and Doug each are the beneficiaries of an ESA. Tom is a senior in a public high school and upon graduation wants to start his own disc jockey business. He does not plan to attend any kind of educational institution and figures that he will learn from the school of hard knocks. His brother, Doug, who is scheduled to graduate from his high school's gifted program next year, has already set his sights on Vassar and will need quite a bit of cash to pay his way through the Ivy League. Tom and Doug's parents, who have funded their sons' ESAs, ask Tom if he will change the beneficiary on his ESA to his brother, Doug. Tom is only too happy to do this, as he wants no part of college at any point. This beneficiary change will make paying for Doug's college education a bit easier. Here's another example: Sally and Shelby are sisters. Sally is just about to turn 30 and is an extremely successful businesswoman who runs her seashell shop by the East Hampton shore. Shelby, who is 17 years old, has recently decided that she would like to be a pediatric nurse and will be attending college for the first time in the fall. Sally is the beneficiary of an ESA and decides that she would like to change the beneficiary to her baby sister, Shelby, since Sally is so successful she doesn't want to go to college and she doesn't need the distribution she would be required to take from the ESA when she reaches age 30. Sally also avoids paying income tax on the mandatory distribution as well as the 10 percent penalty and Shelby receives the benefit of the tax-free earnings from the ESA for use in her college education.