Tax code squishy on 529 plan withdrawal



Dear Joe, Does a scholarship withdrawal from a 529 college savings plan need to be taken in the same year as the scholarship is awarded, or can that withdrawal (with the 10 percent penalty waived) be elected anytime? According to your site, a scholarship withdrawal is a nonqualified distribution requested after the beneficiary receives a tax-free scholarship. For federal purposes, the earnings portion of the distribution is taxable, although the usual 10 percent penalty is waived. -- Jeff


Dear Jeff,

I wish I could give you a 100 percent certain answer to your tax question, but unfortunately I cannot. As so often happens, the tax code is not entirely clear and the Internal Revenue Service has not provided much help to taxpayers in interpreting the law.

It makes perfect sense that if the 529 account beneficiary receives a scholarship, the usual 10 percent federal tax penalty on nonqualified distributions from 529 plans is waived to the extent of that scholarship.

After all, you should not be penalized for having more money in a 529 plan than needed for college expenses when scholarships have caused the situation.

Section 530(d)(4) of the Internal Revenue Code says the penalty exception applies to distributions "made on account of" a scholarship.

My own opinion is that you should able to look back to prior years for scholarships whenever you make a nonqualified distribution. In many cases, you may not be able to determine until after the final semester of school if you'll have money leftover in your 529 plan.

Unfortunately, my opinion is not necessarily going to hold up if the IRS audits your tax return. You and your tax professional are ultimately responsible for any position you take on your tax return.

In Publication 970, the IRS describes the penalty exception in a slightly different way: The penalty does not apply to distributions "included in income because the beneficiary received" a scholarship.

The differences between the tax code and IRS Publication 970 may seem insignificant, but suggest to me that the IRS might want to see the distribution made in the same year as the scholarship.

In the past, I found that scholarship distributions from a 529 plan often worked out very nicely. The earnings portion of the distribution could be reported to the student at zero or low tax cost, and without penalty.

But in 2008 and future years, the "kiddie tax" is expanded to include most full-time college students, thus causing the earnings portion of the 529 distribution in many cases to be taxed at the parents' tax rate.

Popular Questions


Two kids, two 529 plans?

Dear Big Bill,
While it's possible to maintain a 529 plan in just one child's name, even when you intend to send more than one child to college, I generally recommend that families open a separate 529 account for each child.

That's assuming there is no additional cost to maintaining multiple accounts. If your 529 plan charges an annual or quarterly account maintenance fee, check to see if you can avoid the fee by signing up for automatic contributions through payroll deduction or electronic funds transfer)

With a separate 529 plan for each child, it becomes easier for you to tailor the mix of stocks, bonds and stable-principal investments (e.g., stable value, guaranteed principal and money market funds) to the particular ages of your children. When your older child is nearing high school graduation, you may want to ratchet down the level of market risk in her 529 plan. At the same time, you could keep a more-aggressive asset allocation in your younger child's 529 plan, accepting more risk for a potentially higher return. Many 529 plans offer "age-based" investment options that automatically make these adjustments as the beneficiary ages.

Separate accounts for your children also offer more gift-tax leeway. Since your 529 contributions are treated as gifts from you to the account beneficiary, your $15,000 (in 2018) annual gift exclusion will go twice as far with two accounts -- one for each child -- than with just one account.

Financial aid is another reason to recommend maintaining separate accounts. You wouldn't want the investments reserved for your younger child's future college expenses to count against your older child's financial aid eligibility. Be warned: The rules here are rather murky, and the impact of a sibling's 529 account may depend on the college's own policies as well on as the type of aid -- federal or institutional -- being sought.

Finally, I believe that separate 529 accounts allow for better family bookkeeping. There will never be any doubt as to your intention to help send all of your children to college. You'll avoid the uncomfortable position of being asked to explain to a curious 8th-grader why account statements are showing up in the mail with only a brother or sister's name on them. And in the event of your death or divorce, no matter how unlikely, your legal representatives and other family members will have less reason to question your actions in setting up and funding the 529 plans.

Even with separate accounts, you'll continue to have the flexibility to shift the money around in the future. You simply need to make sure that whenever funds are withdrawn from the 529 plan to pay for college they are coming from an account in the name of the child incurring the costs. It's a simple matter to change the beneficiary designation among family members at any time, transfer 529 funds between different family members' accounts or split one 529 account into two. The ability to move assets around the family is a key advantage of 529 plans when comparing other college-savings alternatives, such as Uniform Transfers to Minors Act, or UTMA, accounts.

Original Post: 2005-10-13
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Coverdell ESA vs. 529 Plan: Which to choose? (Script)

The Coverdell ESA and the 529 plan are both excellent college savings vehicles because they are both tax-free when used for college. But many families face a choice: do they use a 529 plan for all of their child's college savings, or do they use a Coverdell for the maximum amount of $2,000 each year and put any any extra savings above $2,000 into a 529 plan? In spite of its low annual contribution cap, Coverdell's are now attracting quite a few families. There are two major reasons for that. One is that only the Coverdell allows you to self-direct your investments, just like you might self-direct the investments in your IRA. The other is that in addition to college expenses, Coverdells can be withdrawn tax-free to pay for a broad range of K-12 expenses, while 529 plans are limited to K-12 tuition. This feature is appreciated most in families planning to send their children to private grade schools, which may include additional costs such as room and board or uniforms. A 529 plan, on the other hand, does not impose age limits or income limits like the Coverdell does and so overall we see a lot more money going into 529 plans than into Coverdells. Plus many savers are happy with the investment choices offered by the 529 plans and don't necessarily want to self-direct their investments. And don’t forget this: your state may be giving you a state tax deduction for using a 529 plan, but there are no states offering a state tax deduction for investing with a Coverdell ESA.

Learn more about Coverdell ESAs.

Original post date 2013-07-15
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Top 529 Plan Withdrawal Tips. (Script)

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Top 529 Plan Withdrawal Tips. (Video)

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