Monthly top tips

So Says the 529 Guru

No. 18
Joe Hurley
Tuesday, March 29th 2005

Question: I put some money into a 529 plan last year. What do I need to show on the tax returns I file next month?

Answer: Probably nothing, at least on your federal tax returns. For state purposes, the answer could be different.

Federal Income Tax Form 1040
If you simply contributed to a 529 plan, and made no withdrawals during the year, nothing has to be shown on your federal income tax return. The contributions are not deductible, and the earnings that build up in the account are not reportable until the year in which they are withdrawn. It cannot get much easier than that.

If you withdrew funds from your 529 account during the year, you should have already received a Form 1099-Q from the plan reporting the distribution and breaking it out into two pieces: basis (non-taxable) and earnings (possibly taxable). Even when a Form 1099-Q is received, you will not have to report anything on your federal income tax return if either of two conditions is met.

The first condition relates to rollovers. A withdrawal is tax-free if it is rolled over within 60 days to another 529 plan naming a different qualifying family member as beneficiary. A rollover where the beneficiary stays the same will also work, but only once in any 12-month period. A rollover does not have to be reported to the government; you simply have to make sure the receiving 529 plan knows it is a rollover and receives the tax basis information from the old 529 plan so that it can keep track of the basis going forward.

The second condition is when all withdrawals during the year are "qualified withdrawals." The beneficiary must have attended an eligible post-secondary institution and incurred "qualified higher education expenses" during the year equal to or greater than the gross distributions reported on Forms 1099-Q. You make this determination off-line; there are no lines on the Form 1040 that lead you through this calculation. Follow the rules described in IRS Publication 970 (http://www.irs.gov/pub/irs-pdf/p970.pdf) for counting up qualified expenses, and for making adjustments as necessary for expenses applied to the Hope or Lifetime Learning credit. If distributions were made from a Coverdell education savings account (ESA) during the same year, the college costs must be allocated between the 529 and the ESA.

If you did not roll over the 529 distribution, and your beneficiary did not incur qualified expenses at least equal to the amount of the distribution, then you WILL have something to report on your or the beneficiary's federal income tax return. The amount of earnings shown on Form 1099-Q should be included on Line 21 Other Income, unless the beneficiary incurred some amount of qualified higher education expenses, in which case only a portion of the earnings should be reported on Line 21. Again, see Publication 970 (http://www.irs.gov/pub/irs-pdf/p970.pdf) for guidance on how to calculate the exact amount to include in income.

Any taxable 529 earnings will also incur a 10% additional tax unless an exception applies. Exceptions exist for distributions attributable to the beneficiary's death, disability, receipt of a scholarship, and when qualified expenses are adjusted by Hope or Lifetime Learning credit expenses. Form 5329 must be filed with the income tax return to report the 10% additional tax.

A couple of last items: First, realize that the recipient of the distribution, as shown on Form 1099-Q, is the person on whose tax return any includable earnings must be reported. The recipient can be either the account beneficiary or the account owner, depending on the circumstances of the distribution. Second, if the Form 1099-Q shows negative earnings, and the distribution was not rolled over, a loss may be claimed as a miscellaneous itemized deduction on Form 1040. Your tax accountant can provide more details about how to report such a loss.

Federal Gift Tax Form 709
Your contributions to a 529 plan are gifts from you to the account beneficiary. You must add your 529 contributions to your Coverdell ESA contributions and any other gifts made to a particular individual during the year. If the total does not exceed your $11,000 annual exclusion (and you did not make any gifts of a "future interest" that do not qualify for the annual exclusion), you should not have to worry about filing a gift tax return. Married individuals are permitted a combined $22,000 per donee when they agree to split their gifts, but a gift tax return will be required to indicate each spouse's consent to the gift-splitting.

If your total gifts exceed $11,000 for any donee, you must file a gift tax return for the year, due April 15 of the following year.

You will also have to file Form 709 to make the five-year spreading election for large 529 contributions. This election permits contributions of more than $11,000 but no more than $55,000 for any one beneficiary to be treated as made ratably over five years for gift tax purposes. Essentially, you would be applying up to five years' worth of annual gift exclusions to an upfront 529 contribution. Form 709 must be filed for the first election year, but not necessarily for subsequent years.

Grandparents making contributions to a 529 plan may need to concern themselves with the generation-skipping transfer tax. The annual exclusion and five-year election rules described above generally apply to the generation-skipping transfer tax, and the same Form 709 is used.

State Income Tax Forms
You will need to refer to your own state's income tax rules, assuming you reside in a state that imposes an income tax. Half the states provide a state income tax deduction for contributions made to the in-state 529 plan. The details of the deduction vary considerably among these states. For example, some states have annual deduction caps while others do not, and one state (Virginia) removes its annual cap for contributors who have reached 70 years of age. And while most states do not require that the beneficiary be related to the donor in any particular way, a couple of states do have a relationship restriction.

The point here is that you may indeed have something to report on your state income tax return for the year of contribution, but there are no general rules. The same applies to any year in which you make a withdrawal or rollover. While most state income tax forms simply piggyback on federal tax treatment in determining what is included in state income and what is not, not every state makes it that simple. You need to understand the rules in your state or rely on a tax professional for help.

State Gift Tax Forms
Only a small handful of states even have a gift tax, and for the most part they go along with the federal gift tax treatment of 529 contributions, including the five-year election. But if you live in a state with a gift tax, you should check with your tax professional to make sure everything is handled properly.

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