Contrary to what some may think, not all withdrawals are tax-free. Therefore, it is important to understand the basics of 529 plan distributions to avoid paying unwanted federal income tax. While it can be confusing, much like venturing into a college classroom, we’ve broken it down into three simple lessons.
Lesson One:
The most important item to consider is the maximum amount of a tax-free withdrawal that can be taken from a 529 plan in a given year. For most students, this will be 100% of qualified education expenses less amounts covered by scholarships, tuition discounts, grants, and costs used to claim the American Opportunity tax credit or Lifetime Learning tax credit. Withdrawn earnings from 529 plans are always federal income tax-free and penalty-free as long as they do not exceed the account beneficiary’s adjusted qualified education expenses for the year. When withdrawals do exceed the adjusted qualified education expenses, all or a portion of the withdrawn earnings can be taxable. Adjusted qualified education expenses include tuition and related costs, room and board, books, supplies, and equipment.
Lesson Two:
When withdrawals are taken, the account owner can determine how they will be paid out. Typically, a check can be made out to the account owner, the account beneficiary, or directly to the educational institution. Keep in mind that a Form 1099-Q will be issued to the individual withdrawing the funds. If the 1099-Q is issued to the account owner, as opposed to the beneficiary of the account, there is a possibility that the IRS may send out a notice assessing additional tax, interest, and penalties because they are unable match up the withdrawals to the beneficiary’s expenses. The taxpayer will then have the burden of responding to the IRS and substantiating the validity of the withdrawals. Additionally, if a portion of the distributions end up being non-qualified, and therefore taxable, it may be more beneficial from an income tax standpoint to report the income on the student’s tax return, because they are usually in a lower tax bracket than the account owner.
Lesson Three:
As mentioned, some or all of the earnings included in 529 plan withdrawals that are not used to cover qualified education expenses must be included in income. Unfortunately, in this situation, the taxpayer will also be subject to a 10% penalty on the taxable earnings. However, the tax penalty does not apply to earnings that are only taxable because qualified education expenses were reduced by items such as scholarships, tuition discounts, grants, costs used to claim the American Opportunity tax credit or the Lifetime Learning tax credit. Additionally, the penalty does not apply to earnings withdrawn after the account beneficiary passes away or becomes disabled. The 10% penalty is calculated on Form 5329, which is filed with the taxpayer’s 1040.
Since the tax rules for 529 plan withdrawals are more complex than some people may realize, it is important to contact your tax advisor before taking distributions. This will help prevent unpleasant tax liability surprises at the end of the year and will help ensure that funds intended for higher education expenses are not wasted on taxes.
We have counseled many clients and helped create a financial strategy that is advantageous and actionable when it comes to helping put their child through college. If you have questions, contact me at dalger@zinnerco.com to learn how you can reduce your tax implications and help make paying for college more affordable.