686 / How are excess distributions from an education savings account treated?

If distributions from the ESA exceed the amount of the designated beneficiary’s “adjusted qualified education expenses” (qualified education expenses less any tax-free educational assistance) for the year, the recipient will be taxed on a portion of the excess distribution and a portion will be treated as the recovery of “basis.” This is because a portion of the ESA is comprised of after-tax contributions and a portion is comprised of earnings generated by the account. Thus, the latter amount is non-taxable and there is an amount includable in gross income. In determining the taxable portion of an ESA excess distribution, consider the following based on the example in IRS Publication 970:

Example: In 2024, Asher receives a distribution of $850 from an ESA of which $1,500 had been contributed in 2023. Asher’s qualified education expenses for that year are $700. In 2024, there were no contributions to the account. Because the 2024 distribution was Asher’s first distribution from the account, his basis is $1,500 (the amount contributed). As of December 31, 2024, the balance in the ESA is $950. The taxable portion of Asher’s distribution is computed as follows:

Step 1 – Determine the basis portion of the distribution. Multiply the amount distributed ($850) by a fraction, the numerator is Asher’s basis in the account at the end of 2023 ($1,500) plus the balance in the account as of December 31, 2022 ($0) and the denominator is the balance of the account as of
December 31, 2023 ($950) plus the amount distributed in 2023 ($850), or

$850 *	$1,500	= $708
	$1,800