Income tax center

How does the 529 plan administrator calculate the earnings portion of a distribution?

[Excerpts from Chapter 3 of The Best Way to Save for College – A Complete Guide to 529 Plans (2014-15 Edition)]

In preparing Form 1099-Q, the plan administrator first calculates the basis portion of the distribution and then subtracts that figure from the total distribution. What's left is the earnings portion¹. In a 529 savings program, the basis portion is calculated using the following equation:

Basis generally refers to the total contributions into the account less prior distributions of basis. The value of the account is determined on the day of distribution.

The calculation is slightly different in a prepaid program. The total distribution is the current value of the tuition and other education benefits your beneficiary received during the year. The basis portion is calculated from the number of tuition credits used or redeemed during the year as a percentage of total credits purchased. For example, if you originally purchased eight semesters of tuition and you use the program to pay for two semesters in a year, the basis portion of the distribution is two-eighths or 25% of the amount you paid for the prepayment contract.

For purposes of these calculations, all 529 accounts within the same state with the same account owner and designated beneficiary must be treated as one account. Accounts in a prepaid program do not have to be aggregated with accounts in the same state's savings program.

Aggregation is performed by the 529 program administrator, and is not a responsibility of the taxpayer, which means that the administrator will need to track your account's basis over time in order to satisfy the distribution reporting requirements. Rollover contributions from another 529 plan, and tax-free transfers from Coverdell education savings accounts and qualifying U.S. savings bonds, pose a special challenge to program administrators because these transfers include untaxed earnings. (These types of transfers are discussed in further detail below and in later chapters.) The basis of contributions associated with these transfers must be adjusted for their untaxed earnings. IRS Notice 2001–81 prescribes the procedures a 529 plan must now employ to ensure this information is properly recorded².

The government's decision to make program administrators responsible for determining the basis and earnings portions of a distribution lifts some of the paperwork burden from your shoulders. You do not have to maintain your own tax basis records.

¹Section 529 applies the provisions of Section 72 to the extent the distribution is not excludable under any other section of the Code (e.g. Section 117 scholarship exclusion).
²Notice 2001-81, 2001-52 IRB (Dec. 26, 2001).

Next: Who reports any taxable earnings, the account owner or the beneficiary?