IRS releases new guidance for 529 distribution reporting

The IRS has released Notice 2001-81, finally giving us some guidance on implementing certain changes made to section 529 by the 2001 EGTRRA tax cuts. The most significant change described in Notice 2001-81 is that 529 plans will not have to verify the use of distributions after 2001. This means that a program can simply pay out a distribution upon request, without requiring documentation. Of course, it may take some time for many of 529 plans to jettison its current procedures, particularly in states where the state income tax, transaction charges, or distribution waiting periods depend on the characterization of a withdrawal as qualified or non-qualified.

Notice 2001-81 also describes the program record keeping requirements for rollover contributions and for calculating the earnings portion of distributions. The IRS will no longer require the end-of-year aggregation of all distributions made to the beneficiary in computing the earnings, and will no longer require that accounts for the same beneficiary with different account owners be aggregated. This should simplify things somewhat and resolve some difficult problems caused by the old aggregation rules.

A newly developed Form 1099-Q reporting 2002 distributions from 529 plans has been posted to the IRS web site. A new form is necessary to reflect the changes of the 2001 EGTRRA. For 2001 distributions, Form 1099-G will continue to be used.

There are several things to note about Form 1099-Q. It will report gross distributions along with the earnings portion and the portion representing basis. It will not indicate whether the earnings are taxable or exempt because the recipient will have to figure that out with his or her 2002 tax return. The 529 plan is instructed to issue the 1099-Q to the beneficiary, if amounts are paid directly to the institution or to the beneficiary; otherwise to the account owner.
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