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The impact of 529 plans on claiming a dependent
Financial Professional Content
If any of your accountant-friends decide to pull an April Fool's prank on you this year, you can get back at them by asking, in all seriousness, "So tell me, how does taking a distribution from a 529 plan affect my client's ability to claim her daughter as a dependent?"
You may just get blank stares from them.
It's not because your friends are anything less than competent as tax professionals, but rather because no one really knows the answer to that question, at least not with any certainty. And the IRS isn't helping much.
It can be an important question, because a tax preparer's stance could determine whether the client is able to take advantage of the dependency exemption, the American Opportunity credit, the Lifetime Learning credit, and the tuition and fees deduction.
On 2012 tax returns, each claimed dependent provides a $3,800 deduction. Also, in order for a parent to claim the $2,500 American Opportunity credit, the $2,000 Lifetime Learning credit, or the $4,000 tuition and fees deduction, the parent must be able to claim the student as a dependent.
In many families, the crucial test for the dependency exemption is the support test. A child that meets the age and relationship tests, but provides more than one-half of his or her own support, cannot be claimed as a dependent.
A child that cannot be claimed as a dependent will in most instances be able to claim a personal exemption on his own tax return, as well an education credit or tuition deduction. Depending on his income situation, this can actually save taxes (especially if the parent is in the alternative minimum tax or has income beyond the phase-out ranges for the exemption, credits, or deduction). Then again, the child may be like many college students and not have enough income to make use of these tax benefits.
Utilizing a 529 plan to pay the student's education costs is apparently considered by some tax professionals to be support paid by the student, not by the parent/account owner. Their reasoning is that the tax law treats the contributions to a 529 plan as completed gifts to the account beneficiary. Furthermore, for any year in which distributions are paid to the school or to the beneficiary, a Form 1099-Q is issued to the beneficiary.
But a taxpayer might argue that the parent remained in full control of the 529 plan, determined when and how the funds were to be used, and had the right to change beneficiaries or even revoke the assets. Doesn't that all suggest that the parent truly "owned" the account and provided the support?
The argument for giving credit to the parent might be buttressed by instructing the 529 plan to make distributions payable to the account owner, and not to the account beneficiary or to the school. This way, the Form 1099-Q identifies the account owner as the recipient. Doing it this way should not make any difference in treatment of the 529 distribution as tax-free.
IRS instructions and publications do not say anything about how 529 distributions are treated in the support test, and I am not aware of any court cases or rulings. In fact, I have never heard of this becoming an issue in IRS audits. But still, a little official guidance would be nice.
Have a happy Aprils Fools Day.