By Keiter CPAs
Overview of 529 Plan Tax Rules
Section 529 plans are designed to promote saving for college and other higher education expenses. Essentially, an account owner sets up the savings plan in the name of a designated account beneficiary who is expected to attend college sometime in the future. Generally, withdrawals from these savings accounts are tax-free, which is the biggest incentive to initiate an account in the first place. However, there are quite a few rules and tax implications governing these withdrawals.
Withdrawals can be made in the name of the account owner or the account beneficiary. From a reporting perspective, it is better to have the withdrawals made in the name of the person who will be benefiting from the withdrawn money. That way, it is easier to trace the taxable nature of the withdrawals. For example, if the account owner intends to use the withdrawn funds for himself or herself, the withdrawal should be made in his or her name. By the same token, if the account owner plans on using the withdrawal for the benefit of the account beneficiary, the withdrawal should be made in the beneficiary’s name.
Some 529 plans are funded with money from a custodial account – an account set up by an adult for the benefit of a minor under a state’s Uniform Gifts to Minors Act (UGMA) or Uniform Transfers to Minors Act (UTMA). In this case, the funds within the 529 plan legally belong to the beneficiary and not the account owner. Therefore, withdrawals from such accounts must be used solely for the benefit of the beneficiary and not for the account owner’s own personal purposes. However, withdrawals from 529 savings accounts that are not funded by custodial account money can be used for either the account owner or the beneficiary.
Any year that a 529 withdrawal is taken, the plan will issue Form 1099-Q to either the account owner or beneficiary, depending on whom the withdrawal was made out to. The form reports withdrawn earnings and withdrawn basis amounts. As long as the account earns money above owner contributions, any amount withdrawn will reflect a certain portion of withdrawn earnings which may or may not be taxable. Withdrawn basis is simply the withdrawn amount attributed to owner contributions – this portion of the withdrawal is never taxable. The IRS also receives a copy of this 1099-Q, so the recipient must be sure to report it on his or her tax return!
As indicated above, withdrawn earnings may or may not be taxable. Withdrawn earnings are taxable to the extent that they exceed Adjusted Qualified Education expenses (AQEE), which is essentially all qualified education costs less tax-free scholarships, tuition discounts, and other tax-free educational funding received. For example, AQEE would be $20,000 assuming qualified education costs are $50,000 and tuition discounts received are $30,000. Assume that a 529 account withdrawal was made for $50,000 to cover the costs, and of that amount, $10,000 is earnings and $40,000 is basis. In this scenario, AQEE makes up 40% of the withdrawn amount ($20,000 / $50,000). Therefore, only 40% of the withdrawn earnings of $10,000 is tax-free, or $4,000. The remaining $6,000 would be taxable as miscellaneous income on the withdrawal recipient’s tax return.
10% 529 Account Penalty
A penalty tax of 10% may apply to taxable withdrawn earnings from a 529 account. However, the penalty does not apply if taxable withdrawn earnings are only taxable due to a reduction in AQEE through tax-free scholarships, tuition discounts, and other tax-free educational funding. Thus, no penalty would apply in the above example since the withdrawn earnings of $10,000 would have been tax-free had $30,000 of tuition discounts not been received. In contrast, if AQEE had been $0 (without any tax-free educational funding deductions) and withdrawn earnings were still $10,000, the entire $10,000 would be taxable and subject to a 10% penalty of $1,000.
In summary, it is important to gain a basic understanding of the tax consequences of 529 withdrawals before they are made in order to prevent avoidable taxable income and/or penalties. As gathered from the above, the rules are not as straightforward as some might initially think!
Need advice on withdrawing from a 529 plan? Keiter can help. We can provide you with the resources you need to reach your business goals. 804.747.0000 | Email us.
About the Author
The information contained within this article is provided for informational purposes only and is current as of the date published. Online readers are advised not to act upon this information without seeking the service of a professional accountant, as this article is not a substitute for obtaining accounting, tax, or financial advice from a professional accountant.