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What are the federal income tax rules for 529 plan participants?
[Excerpts from Chapter 3 of The Best Way to Save for College – A Complete Guide to 529 Plans (2015-16 Edition)]
Your contributions to a 529 plan are not deductible in computing your federal income tax. Your initial tax savings come from the deferral of income—earnings in your account remain tax-free until they are distributed. Distributed earnings may or may not be subject to tax, depending on whether the designated beneficiary incurs sufficient qualified higher education expenses (QHEE), as adjusted (AQHEE), during the year. AQHEE means total qualified higher education expenses (QHEE) reduced by expenses used to claim an education tax credit.
If you withdraw funds from your 529 account, or have payments made by the program to the beneficiary’s school, the program administrator is responsible for sending Form 1099-Q to you or to your beneficiary after year-end reporting the gross distributions and breaking out the total between earnings and basis (return of principal). Distributions are always allocated pro-rata between earnings and basis. You will need the gross distributions and earnings figures when completing Form 1040, the federal income tax return. Basis always comes out federally tax-free.
If the account beneficiary has incurred AQHEE during the year that in total are equal to, or greater than, the total distributions from all 529 accounts as reported on Forms 1099-Q, the distributions are excluded from income and not reported on Form 1040. If, however, total AQHEE are less than total distributions, only a portion of the distributed earnings is excluded from income, and the remainder has to be reported as ordinary income. The calculation follows this formula:
Gross Distributions – AQHEE | ||
x Earnings= Ordinary Income | ||
Gross Distributions |
If withdrawals are made from a Coverdell education savings ac-count for the same beneficiary during the year, QHEE must first be allocated between the 529 distributions and the Coverdell withdrawals. This is because withdrawals from a Coverdell ESA follow the same general taxation rules as distributions from a 529 plan. IRS Publication 970 suggests a pro rata allocation of expenses, but the IRS apparently will permit any other reasonable method.
Can I take distributions from my 529 plan in this calendar year to reimburse myself for last year’s college costs, or, alternatively, to provide funds for next year’s college payments?
This question does not appear to be fully resolved by the IRS. The timing of the transaction will not be a concern if the distribution from the 529 plan is made payable directly to the school, but it can become an issue if you pay the college bills yourself. For example, let's assume you withdraw funds from your 529 account in December 2015, but wait until January 2016 to pay the tuition bill. A Form 1099-Q will be issued for 2015, but the tuition presumably counts as a 2016 expense, and you could end up paying tax and penalty because of the mismatch. This can also happen in the other direction. Let's assume you pay the tuition in late December and request a distribution from the 529 plan to reimburse yourself for the payment. If the distribution is processed in January of the following year, you potentially face a tax problem.
In Announcement 2008-17, the IRS announced that new regulations are expected to include a provision permitting qualified higher education expenses paid during the first three months of the year to be treated as the previous year’s expenses. While this would eliminate the problem in the first scenario described above, it would not help with the second scenario (the reimbursement mismatch). Until further guidance is issued by the IRS, you should assume that 529 account distributions and the payment of qualified expenses must occur within the same calendar year.
What is the 10% penalty?
Earnings subject to tax because they are part of a nonqualified distribution are also subject to a 10 percent federal tax. This tax, which represents the penalty for using a 529 account for purposes other than higher education expenses, is computed on Form 5329 as part of the Form 1040.
Note the following exceptions to the 10% penalty tax:
- The distribution is made because the beneficiary is disabled—i.e., unable to engage in any substantial gainful activity because of a physical or mental condition, and the condition is of indefinite duration or is expected to result in death.
- The distribution is made on account of tax-free scholarships or allowances received by the beneficiary, but only to the extent the distribution did not exceed the amount of scholarship or allowance.
- The distribution is made due to beneficiary's attendance at a U.S. military academy, to the extent the distribution does not exceed the costs of advanced education (as defined in Title 10 of the U.S. Code) at the academy.
- The distribution is paid to the beneficiary (or to the beneficiary’s estate) on or after the death of the beneficiary.
- The distribution is included in income only because total qualified higher education expenses had to be reduced by tuition and related expenses used in computing the American Opportunity credit or Lifetime Learning credit.
Next: How does the 529 plan administrator calculate the earnings portion of a distribution?
- What are the federal income tax rules for 529 plan participants?
- How does the 529 plan administrator calculate the earnings portion of a distribution?
- Who reports any taxable earnings, the account owner or the beneficiary?
- What about state taxes?
- What are adjusted qualified higher education expenses?
- Can I claim the American Opportunity or Lifetime Learning credit in the same year that I withdraw from my 529 account to pay for college?
- How about the above-the-line deduction for qualified tuition and related expenses?
Can I claim the deduction for expenses I pay using funds from my 529 account? - Can I change the beneficiary of my 529 account?
- Can I transfer my account from one state’s 529 plan to another state’s 529 plan?
- Can I transfer the ownership of my account to someone else?
- Where do I show the beneficiary's qualified higher education expenses to the IRS?
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