Record-keeping for your 529

http://www.savingforcollege.com/articles/record-keeping-for-your-529

One of the under-appreciated conveniences provided by a 529 plan is that you don’t have to keep your own records showing the history of your contributions and withdrawals. The tracking of your tax "basis" is performed for you by the program manager. Until you begin taking distributions, you won’t have to devote file cabinet space to your 529 plan, and you also won’t run the risk of making a mistake in tracking basis that could result in an underpayment or overpayment of tax.

Your primary record keeping responsibility comes down the road, in a year you take distributions from your 529 account. You’ll have to tally the qualified higher education expenses (QHEE) of your beneficiary for that year, which includes tuition, mandatory fees, and required books, supplies, and equipment. For students pursuing a degree on at least a half-time basis, QHEE also includes a capped amount of room and board. And "special needs items" can be counted for as-yet undefined "special needs beneficiaries."

If you, or your beneficiary, are claiming certain other education tax benefits, such as the Hope or lifetime learning credit, you’ll have to reduce total QHEE under the anti-double-dipping rules. The new total is called "adjusted" qualified higher education expenses, or AQHEE.

Whenever total AQHEE for the year is equal to, or more than, the distributions from the 529 plan for that same year, you’re pretty much done—there’s no income to report. You or your beneficiary (depending on how you choose to have the distributions paid) will receive a Form 1099-Q from the 529 plan showing your total distributions for the year, the earnings portion of those distributions, and the basis portion. But the earnings and basis figures become meaningless. In fact, nothing at all needs to show on Form 1040.

Unless your own state has some special requirement relating to its state tax incentives or a contribution matching program, you will not be required to report your beneficiary’s college expenses directly to his or her school, to the 529 plan, or to anyone else. However, just like with charitable donations and property tax deductions, you will need to maintain your receipts and other records of AQHEE in preparation for the day the IRS selects your tax return for examination and asks to see documentation.

If the amount of AQHEE falls below the amount of distributions, the difference is known as a non-qualified distribution and the tax picture changes. Some or all of the earnings reported on Form 1099-Q will have to be included as income on the Form 1040 of the 1099-Q recipient. The amount to report must be calculated under a formula described in IRS Publication 970 that uses the ratio of non-qualified distributions to total distributions The taxable earnings will also be subject to an additional 10-percent tax penalty, unless an exception applies.

Here are a few tricky parts to these tax rules:

• The adjustments that take QHEE to AQHEE. For example, using $10,000 in tuition to generate a $2,000 lifetime learning credit means a $10,000 reduction in 529-qualified expenses, even when you can show that the 529 money went to pay for that tuition. You (and your tax preparer if you use one) should plan for this beforehand. Many taxpayers will have their choice of education tax benefits and they must decide on the approach that gives them the biggest break. Significantly, when an adjustment to QHEE results in taxable income on 529 distributions, the 10-percent penalty is waived.
• Room and board. If the student is living off-campus, you’ll need to ask the school for its cost-of-attendance allowance for room and board as reported to the U.S. Department of Education. Be sure you can document the student’s expenses for room and board up to the school’s allowance. Although not technically necessary, it’s a good idea to document some expenses over and above the allowance in the event you and the IRS cannot agree on whether certain costs, such as beer or protein shakes, are properly considered part of room and board.
• Allocation of expenses. It’s conceivable, but not common, that Forms 1099-Q will be issued to multiple recipients for the same tax year. For example, you, the student beneficiary, and even the grandparents with their own 529 accounts may all be receiving distributions. If this happens, you’ll need to divvy up the AQHEE among the Form 1099-Q recipients. The IRS does not provide any rules for allocating the expenses, so you’ll have to agree on a reasonable approach if you ever face this situation.

Originally Posted February 20, 2009