Monthly top tips

So Says the 529 Guru

No. 4
Joe Hurley
Wednesday, December 4th 2002

Timing is everything, so they say. Here are a couple of questions that illustrate that fact.

Question: I would like to make a withdrawal from my 529 plan for qualified expenses I incurred in 2002 before I set up the account. Any idea if this is acceptable to the IRS? Thanks! - "Jermar" on the Message Board.

Answer: Should be no problem, Jermar. The IRS does not require that your withdrawal be traceable to specific educational expenditures. Instead, think of the taxation of 529 withdrawals as a two-step process:

Step 1 is to throw all of the beneficiary's qualified higher education expenses (QHEE) for the year into one "bucket."

Step 2 is to throw all 529 withdrawals into a second bucket. Then, compare this withdrawal bucket to the QHEE bucket. As long as the withdrawal bucket is smaller, you don't have to worry about federal income tax. The withdrawn earnings are tax-free.

What happens if the withdrawal bucket is bigger than the QHEE bucket? Well, that's when you have to go to Step 3: calculating how much of the earnings portion of your withdrawal is taxable, and, possibly, subject to a 10% federal penalty. The IRS last month (November 2002) came out with Publication 970 containing instructions. You, or the beneficiary, will have to use these instructions to compute the amount of income subject to tax and penalty when preparing 2002 income taxes.

Although direct tracing is not required, I believe it's still important to match up your 529 plan withdrawals and college expenditures within the same calendar year. If you pay a bill on December 26 and request a withdrawal from your 529 plan that is not processed until next January, I think you may have a tax problem. Publication 970, although helpful in answering many questions, does not confirm or deny my reading of the tax law regarding this particular issue.

Question: I understand that I have until April 15 of next year to make contributions to my child's Coverdell education savings account. If I wait until then, will the contribution count as a gift in 2002 or 2003? - BW

Answer: Great question. The IRS has not yet issued any formal set of regulations covering Coverdell ESAs, nor have their technical people answered my inquiry yet on this particular topic. I believe the contribution you make to your child's ESA will count as a gift to your child in the year you make the contribution, even if you choose to label it as a prior-year contribution. If you are well below your $11,000 annual gift exclusion in the total amounts of gifts being made to any one individual in a given year (including ESA contributions and 529 plan contributions), the answer should not make any difference. But if you are close to the exclusion limit, or above it, then it could make a difference. Please check with your tax adviser.

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