November 08, 2021

Taxation of 529 Plan

Several payment options: 

There are two terms that are used to describe a person who manages a 529 plan: “account owner” or “plant participant”. If you are that person, you have an option to withdraw funds through a cheque that is cut in your name. Alternatively, you can transfer the money electronically.

Other than this, you have an option of issuing the withdrawal in the name of the account beneficiary. (In most cases, it’s the child or grandchild for whom this 529 plan account was established).

Or you can also pay directly to the educational institution your child attends. It is up to you what payment options you choose, and you can select the preferable option when submitting a withdrawal request to the 529 plan.

Withdrawal information to the IRS:

The IRS gets notified whenever there is a withdrawal from a 529 account.

There are two situations:

·       When the withdrawal is in the name of the account owner, then the form 1099-Q goes to the owner.

·       When the withdrawal is in the name of the beneficiary, then the form 1099-Q goes to him or her.

Whatever the situation is, the IRS gets a copy of such a form as a piece of evidence and knowledge about the withdrawal.

Taxable withdrawals:

The withdrawn earnings are both federal income tax-free and penalty-free when the total withdrawal amount does not exceed the AQEE of the year. AQEE is a fancy term for qualified expenses.

AQEE includes:

·       College/ tuition fees.

·       Up to 10k in K-12 tuition costs.

·       Books, supplies, etc.

·       Computer hardware, software, and internet service cost.

·       Room or board in case of full-time study.

·       Up to 10K in interest and principal payments on qualified student loan debt owed by the account beneficiary.

In order to calculate the tax-free portion of your withdrawal, you would need to subtract any tax-free assistance you received from the government.

Following are the points that are included in federal income tax-free educational assistance:

·       Pell grants i.e. tax-free;

·       Scholarships, fellowships, and tuition discounts (tax-free);

·       Veterans’ educational assistance;

·       An employer’s educational assistance program under Internal Revenue Code Section 127 is tax-free; and

·       Other tax-free educational help (does not includes help received in the form of a gift or an inheritance).

·       American Opportunity or Lifetime credit you claimed on your tax return.

Key Point: If your withdrawals exceed your qualified tuition expenses (AQEE), then all or a part of the withdrawn earnings can be taxable. When you withdrew money and all of it was applied towards education expenses and there was no tax-free assistance, then you should not be paying tax on your withdrawal.

Tax consequences on withdrawals used for other purposes:

If you were the one who funded the account, you can change the beneficiary to yourself and withdraw the money for your own school expenses. But if you withdrew the money and used it for other purposes, then you have to report this amount as the miscellaneous income on your form 1040. Withdrawals for personal purposes are also subjected to a 10% penalty.

However, there are several opportunities where a 10% penalty does not apply to the withdrawn earnings:

·   If your account lost in value (its value was less than your original contributions), and you liquidated it

·   If the account beneficiary becomes disabled or dies.

·   If the account beneficiary attends the U.S military academies, such as the Air Force Academy or West Point.