Are Education Trust Fund Disbursements Taxable?

Education trust funds help parents and other relatives save for a child's education and provide some possible tax benefits. As long as the contributors stay in the gift tax exemption range of under $13,000 per year, most of the money in the trust can be distributed tax-free. However, the trust must pay taxes on any income -- interest, dividends -- over $600 each year and can choose whether to make the beneficiary pay taxes.

When a parent, relative or friend sets up an education trust fund, she becomes a grantor in the trust. She transfers assets -- and ownership over those assets -- to the trust, which a named trustee administers. The trustee can be a professional, or a relative or friend. The grantor also names a beneficiary, who can use the funds toward education expenses once she fulfills the conditions set out by the trust's guidelines, such as turning 18 or enrolling in a college.

The grantor and others in the child's life can continue to contribute to the trust fund. Contributors can put in up to a certain amount annually with no gift tax ramifications. The gift tax exemption was set at $13,000 per recipient in 2011, but the amount changes frequently because of tax code wrangling. If a contributor passes the $13,000 limit, she may owe gift taxes if she also passes her $5,000,000 total lifetime gift-giving limit. Note that the person giving the gift owes taxes, not the recipient.

Trusts invest money in bonds, the stock market, mutual funds, certificates of deposit, savings accounts and other vehicles that generate income in the form of interest and dividends. The trust owes income taxes each year on any income above $600. The trust can pay these taxes or disburse the income along with the tax burden to the beneficiary. When the trust makes a disbursement, it should also send out a 1041 (K-1) form, which is a tax form that states clearly whether the trust paid taxes on the money and if the beneficiary owes taxes on trust income.

Grantors gift most of the money in the trust fund, meaning that any money coming from gifted funds is tax-free. No one owes taxes on it, not the grantor, trust or beneficiary. The trustee has the responsibility to keep an account separating trust income from other money in the trust.