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Court: Failed 529 rollover triggers tax, no penalty

(November 11, 2011) - In Karlen v. Commissioner, T.C. Summary Opinion 2011-129 (Nov. 10, 2011) the U.S. Tax Court decided that the taxpayers owed federal tax, but not the 10% tax penalty, on distributions from a 529 plan that were not properly rolled over.

The husband, Timothy Karlen, requested distributions from his North Carolina 529 accounts to pay household expenses, but at the urging of his wife returned the endorsed checks to the 529 plan for redeposit. Although the redeposits took place within 60 days, they failed to qualify as rollovers since they went back into accounts for the original beneficiaries, which disqualified them from tax-free rollover treatment.

Although tax was owed on the earnings portions of the distributions, the court felt it would not be proper to impose the 10% federal penalty, considering the circumstances.

As a Tax Court Summary Opinion, the case cannot be used as precedent. Indeed, the court's decision to waive the penalty was a questionable one, since there is no provision in the Code for waiving the penalty based on a taxpayer's honorable intentions.

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