Monthly top tips

So Says the 529 Guru

No. 2
Joe Hurley
Monday, September 30th 2002

Hi everyone. Here are a couple of forward-looking questions I've received.

Question: The 10% penalty for non-qualified distributions from a 529 plan is not assessed if the funds were not needed because the beneficiary received a scholarship. Does an appointment to a federal service academy (West Point, the Naval Academy, the Air Force Academy, etc.) qualify as a "scholarship"? And what dollar value would be attached to such an appointment? - Ramjet (from our Message Board)

Answer: To impose the 10%-of-earnings penalty because your child attends a military academy would seem downright unpatriotic, don't you think? Yet that appears to be the case.

Past rulings from our friends at the IRS suggest that the subsidy for cadets and midshipmen does not amount to a scholarship as that term is defined in tax law. This makes 529 plans and Coverdell accounts less attractive to families that may be in line for such an appointment.

The good news is that some in Congress have recognized the problem and are pushing for an amendment to the law. Unfortunately, a bill containing that fix was recently rejected in the House of Representatives. This was the same bill that would have made permanent the education tax incentives contained in last year's tax cuts (see Guru 02-01 ).

It seems pretty clear that this trap in the tax law was unintentional and will likely be changed before too long. Even if a formal amendment were slow in coming, I would hope that the IRS decides to make an administrative decision to treat a service academy appointment as a scholarship for this particular purpose. It remains to be seen how a dollar value could be attached, if in fact the academy does not post an official "tuition" figure.

One last point deserves mention here. Although the 10% penalty is waived on a scholarship distribution, the tax is not. A scholarship distribution is still considered a non-qualified distribution, and you or your beneficiary will have to report the earnings portion as ordinary income. You might better leave the unspent money in the 529 account and look to use it for the future college expenses of other family members.

Question: If someone transfers their child's Coverdell education savings account to a 529 plan, and in 2010 the tax exemption for 529 plans expires, can the money be transferred from the 529 plan back to the Coverdell account? - CP

Answer: That sounds like a sensible solution to the problem of the 2010 "sunset," CP, but unfortunately the transfer rule is a one-way street. You can put your Coverdell money into a 529 plan without triggering tax or penalty, but it doesn't work the other way around.

It is for this reason that you should not be too quick to transfer funds from a Coverdell account to a 529 plan. Unless there is another compelling reason to make the switch, such as when the beneficiary is about to turn age 30 and trigger the liquidation of the Coverdell account, you should probably leave the account alone at least until Congress decides to make permanent the exclusion for qualified withdrawals from a 529 plan. Otherwise you may be converting future tax-free Coverdell withdrawals into taxable 529 withdrawals.

Don't jump to the conclusion that the Coverdell account is a better investment than the 529 plan just because Coverdell accounts retain their tax-free status for college expenses after the year 2010. There are many other differences between these two competing college-savings vehicles. Also, be aware that the 2010 sunset will hit the Coverdell account just as hard, but for other reasons. For example, in 2011 you will no longer be able to claim both the Coverdell exclusion and the Hope or Lifetime Learning credit in the same year, and so most students will elect to pay tax on Coverdell withdrawals in order to obtain the more valuable credits.

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