Who Pays Taxes on a Non-Qualified 529 Plan Withdrawal?

Withdrawals from a 529 plan are tax-free if they are used to pay for a qualified education expense. However, non-qualified distributions are subject to taxes and penalties. The person responsible for reporting the non-qualified distribution on their income tax returns depends on the recipient of the taxable withdrawal.

Withdrawals from a 529 plan may be paid directly to the educational institution, the beneficiary, or the account owner. Either the account owner or the account beneficiary will have to pay federal income tax on the earnings portion of a non-qualified withdrawal plus a 10% tax penalty, as shown in this chart.

For example, if a parent takes a non-qualified distribution from the 529 plan to pay for travel costs, the parent will pay the taxes if the check from the 529 plan is in the parent’s name. On the other hand, if the parent sends money directly to a college to pay for a non-qualified expense, such as health insurance, the beneficiary will be responsible for reporting this non-qualified distribution on their tax return.

This is because the Internal Revenue Code of 1986 requires non-qualified distributions to be included in the distributee’s gross income. [26 USC 529(c)(3)(A)]

The recipient listed on the 1099-Q must report the taxable earnings portion on their tax return. The instructions for IRS Form 1099-Q state:

QTP. List the designated beneficiary as the recipient only if
the distribution is made (a) directly to the designated
beneficiary, or (b) to an eligible educational institution for the
benefit of the designated beneficiary, or (c) directly (trustee-to trustee transfer) to a Roth IRA maintained for the benefit of the designated beneficiary. Otherwise, list the account owner as the recipient of the distribution. Enter the TIN for the applicable recipient.

This means the parent will handle the taxes if the parent is listed as the recipient on the form. Similarly, if the beneficiary receives the distribution, they are responsible for reporting it.

This contrasts with a Coverdell Education Savings Account, where the beneficiary is considered the recipient of all withdrawals.

In addition to federal income taxes, the non-qualified distribution must also be reported by the account owner or beneficiary on their state tax return, if applicable. Note that not all states conform to the federal definition of qualified education expenses. Check your state’s definition of qualified expenses to determine what needs to be reported on state tax returns.