Monthly top tips

So Says the 529 Guru

No. 11
Joe Hurley
Tuesday, January 27th 2004

Question: I am 43, and I plan on quitting my current job in a year to go back to school. Can I set up a 529 plan with me as the beneficiary, and then roll over my 401k into that plan directly? If not, can I roll over my 401k into an IRA account and then from there into a 529 plan with me as beneficiary?

Answer: It's great that you're planning in advance to attain your educational goals. Many adults with a desire to attend postsecondary classes will find that a 529 plan will help them accumulate the needed funds in the most tax-efficient manner.

Unfortunately, the law currently does not permit you to transfer funds tax-free from a 401k or IRA into a 529 plan. Any distribution you take from your retirement plan for the purpose of depositing to a 529 plan will be taxed and, perhaps, subject to an early withdrawal penalty.

That news may not be as bad as it sounds. If your income drops after you quit your job to attend classes, you may find that your tax bracket drops as well. An added benefit is that IRA withdrawals used to pay qualified higher education expenses are not subject to a 10% early-withdrawal penalty. And you may qualify for a federal education credit of as much as $2,000 to offset your taxes. Another piece of advice: Don't quit your job until you find out if your employer offers an educational assistance program as a tax-free benefit. (If all this sounds confusing, it's because it is confusing. Download IRS Publication 970 and/or purchase our Year End Tax Guide to Education Tax Benefits.)

Your question provides the opportunity to review the types of transfers to a 529 plan that can be accomplished without triggering federal income taxes. The most common are the following:

From a Coverdell education savings account (ESA) to a 529 plan
Simply withdraw from the ESA and make sure contributions at least equal to the withdrawal amount are made to a 529 plan for the same beneficiary in the same calendar year. This may be a good idea when the ESA beneficiary is nearing the ESA required distribution age of 30 and you want to keep the funds invested on a tax-deferred basis. (Most 529 plans have no age limits.) It could also make sense when an ESA investor has an opportunity to capture some state-specific benefits in a 529 plana state income tax deduction on contributions, for example.

From an Education Savings Bond to a 529 plan
U.S. savings bonds may be redeemed tax-free when certain conditions are met. The bond must be a Series EE bond issued after 1989, or an I Bond, purchased and owned by an individual at least 24 years old before the month of purchase. In addition, the bondholder must have modified adjusted gross income below a threshold in the year of redemption (the upper limit of the phase-out in 2004 is $74,850, with joint filers at $119,750) and the bondholder, the bondholder's spouse, or the bondholder's dependent must incur qualified higher education expenses at least equal to the amount of bond redemption proceeds. A contribution to a 529 plan is considered a "qualified" expense when redeeming a bond, even when the beneficiary has not reached college age. Consider making this move if you expect your income to be beyond the phase-out by the time college rolls around, but find that you're within the income limits in the current year.

From one 529 plan to another 529 plan
The law permits federal tax-free rollovers between 529 plans. Simply withdraw from your current 529 plan and within 60 days contribute the funds into another 529 plan for the same beneficiary, or for another beneficiary who qualifies as a family member of the first beneficiary. You must be careful here. You are limited to one same-beneficiary rollover in any 12-month period. You may want to switch the beneficiary to a sibling as part of the rollover process just to avoid any possible problems.

Question: I have a question about taxes on a distribution from a 529 plan. How would the government know if you did not use the money for educational purposes? I thought there was a mechanism in place, but can't find mention of it anywhere.

Answer: You may be thinking of the "old" rules when states were required to impose penalties on nonqualified withdrawals from their 529 plans. You were supposed to substantiate the use of your withdrawals by providing the 529 program administrator with copies of tuition bills and other qualifying expenditures.

Thank goodness that all went out the window at the beginning of 2002. States are no longer required to verify the use of 529 withdrawals or impose a penalty on nonqualified withdrawals. Instead, you must calculate and report any income and penalty with your federal income tax return. The way the government checks on you is that great American ritual known as the IRS audit. You must retain documentation of the beneficiary's qualified higher education expenses and be prepared to produce it if the IRS examines your return. Additional tax and penalties (or worse) await the 529 account owner who fails to properly pay taxes and penalties on nonqualified withdrawals.

Unknown to many is the fact that the states may be forced to start imposing their own penalties again beginning in the year 2011. The federal 10-percent penalty, along with every other provision of the 2001 tax cut law, is slated to expire at the end of 2010. It's a fairly safe bet that Congress and the President will agree to make the 10- percent federal penalty permanent before the year 2010 rolls around. We hope they also decide to make permanent tax-free withdrawals from a 529 plan!

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