Monthly top tips

So Says the 529 Guru

No. 16
Joe Hurley
Monday, November 29th 2004

Question: My husband and I have been putting money into a 529 plan for our daughter Jesse over the past couple of years and our account has grown nicely in value. Jesse started college this fall and we paid her tuition and other college bills with money from our checking account. We were fortunate that the college provided Jesse with an academic scholarship covering 65% of her tuition. Now we would like to withdraw money tax-free from the 529 plan to reimburse us for the costs we paid out of pocket. But we're not sure if we should also withdraw the amount of the scholarship. Can you help us? Nancy I.

Answer: This is a tricky issue. The amount that can be taken tax-free from your 529 account is limited to the amount of qualified higher education expenses incurred by Jesse during the year. Anything more is considered a "non-qualified" withdrawal, reportable on your or Jesse's federal income tax return. The "good news" is that the normal 10% federal tax penalty on non-qualified withdrawals is waived when withdrawals are attributable to a scholarship.

If you are fairly certain that Jesse will incur enough qualified higher education expenses in future years to fully consume the funds in your 529 account, you may want to leave the scholarship amount in the 529 plan, and keep all your withdrawals tax-free. However, if you think there is a good chance you will end up with more money in your 529 account than is needed to pay Jesse's college costs, you may want to withdraw the scholarship amount now and avoid the risk that unspent funds become subject to the 10% penalty when withdrawn in the future. Just be sure to request that the 529 withdrawal be made payable to Jesse, not to you, so the 529 earnings are reported on her tax return and not yours (I'm assuming that Jesse, like most first-year college students, is in a low tax bracket.)

Unfortunately, the tax law is not clear on whether or not the penalty exception for scholarships applies only for the calendar year in which the scholarship is provided. It would be helpful if the IRS allowed you to count all scholarships received in prior years when determining the applicability of the 10% penalty for withdrawals in the current year, but the guidance we've received from IRS thus far does not address this issue. (The 2004 version of Publication 970 Tax Benefits for Education has just been released.)

Remember also that Jesse's qualified higher education expenses must be reduced by any tuition used in generating a Hope tax credit or the Lifetime Learning credit. This adjustment is sure to affect many families. The results are similar to the scholarship scenario described above: Although some of the withdrawn 529 earnings may become taxable, the amount attributable to the credit adjustment will not be subject to the 10% penalty.

For more information about these adjustments, see Publication 970 or order our 24-page guide, 2004 Year-end Planning for Education Tax Benefits ($8 plus shipping).

Question: I am a New York State resident and plan to roll over funds from a non-New York 529 plan to the New York 529 plan. My question is: Do I get a New York state tax deduction for the amount I am transferring into the New York plan? Thanks for your help. Brian C.

Answer: I wish I could say for certain, Brian, but I cannot. To my knowledge, the New York State Department of Taxation and Finance (DTF) has not yet provided a definitive answer to that question. While my own research indicates that a rollover contribution is treated like any other contribution for purposes of the New York deduction, and thus should qualify for the deduction, it is altogether possible that DTF may have a different opinion (and the history of DTF guidance on 529 issues in the past is not very comforting). Ultimately, you need to rely on your own tax professional for guidance.

The question of tax deductibility of rollover contributions comes up in every state offering a state income tax deduction. The states that have indicated to me that rollover contributions do not count for deduction purposes include Colorado, District of Columbia, Illinois (but only for the earnings portion), Kansas, Maryland, and Rhode Island. But in some of the tax-deduction states not listed here, like New York, the question is one that has not been officially addressed.

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