Closing 529 plan triggers tax headaches



Dear Joe, I opened a 529 plan for my son, but recently closed it because of the sinking stock market. In the time it was open, I made a gain of $3,000. How much in taxes will I have to pay on this account? My son is under 10. Can you advise me on what is the best account to open for him? I don't want to open an aggressive 529 account. Can I open a CD custodial account? -- Vimala


Dear Vimala,

The tax consequences depend on who received the money from the 529 plan: you or your son. If you, as account owner, requested the refund, you will be responsible for reporting the gain on your federal income tax return as "other income."

The 529 plan will send you a Form 1099-Q shortly after the end of the year. This document reports your distribution and breaks it down between basis (nontaxable) and earnings. Besides paying tax on the earnings at ordinary income rates, you will also be subject to a 10 percent penalty tax on the earnings. Compute this on Form 5329 and attach it to your Form 1040.

For example, let's assume you are in the 25 percent federal income tax bracket. You'll owe total tax and penalty on your nonqualified 529 distribution equal to 35 percent of the gain.

If you live in a state with an income tax, you will also owe state income tax on the earnings. This even includes tax on the "recapture" of any income tax deductions you may have claimed on your state taxes when contributing to the 529 plan.

The refund you receive from the 529 plan is yours to do with as you please. You may decide to reinvest the proceeds in a CD or other investment vehicle in your own name. If you invest the money in a custodial account (such as by using Uniform Transfer to Minors Act provisions) for your son, the amount that goes into the account is considered a gift for gift-tax purposes.

On the other hand, if you requested the distribution from the 529 plan be paid directly to your son as beneficiary, Form 1099-Q will be issued with his Social Security number. This means the earnings will be reportable (along with the penalty) on his federal income tax return.

Your son's tax bracket is likely to be much lower than yours. However, the "kiddie tax" requires that unearned income in excess of $1,800 be taxed at the parents' marginal tax rate, not the child's. Since you've pegged your gain at $3,000, you can be sure that the kiddie tax will apply to at least $1,200 of the gain.

A distribution from the 529 plan made payable to your son means the money legally belongs to him. If you reinvest the proceeds on his behalf, the investment should be set up in a UTMA/custodial account. There's no gift involved; you made the gift with your original contributions to the 529 plan.

Regarding the best type of investment going forward, a bank CD is a very safe option, although the interest may not keep up with rising college costs. (I happen to prefer the age-based options found in many 529 plans, even in a weak stock market.)

However, buying a bank CD outside a 529 plan means the interest will be fully taxable. By contrast, a CD purchased inside a 529 plan will provide for tax-free interest if the money is eventually used for qualifying college costs.

You can find good CD options in several 529 plans, with Ohio and Wisconsin offering the most flexible choices. You may even avoid taxes on your $3,000 gain if you received the money within the last 60 days and reinvest it with another 529 plan within the 60-day rollover window.