Tax-favored Section 529 college savings plans — also known as qualified tuition programs — have been around long enough that many people are now withdrawing money to pay for school. Qualified withdrawals are always federal-income-tax-free and usually state-income-tax-free, too. However, the full story isn't quite so simple. Here are the key details.
There are several ways to access the money in a Sec. 529 account. You can have the withdrawal check issued in the name of the Sec. 529 account beneficiary or have an electronic funds transfer made into the bank account of the Sec. 529 account beneficiary — the student for whom the Sec. 529 account was set up, which is usually your child or grandchild — or the payment can be made to the college.
Alternatively, you can have the check issued in your name or have an electronic funds transfer made into to your bank account as the Sec. 529 plan account owner or plan participant. (Both terms are used to describe the person who established and funded the Sec. 529 account.)
Follow these basic principles to have the tax consequences "follow the money."
It's important to understand that you're not allowed to keep a withdrawal from a Sec. 529 account that was funded with money from a custodial account set up for the Sec. 529 account beneficiary (usually your child or grandchild). In this situation, any money taken from the Sec. 529 account belongs to the account beneficiary and can be withdrawn only for a purpose that benefits the child, such as buying the beneficiary a car.
On the other hand, if you funded the Sec. 529 account with your own money, the money in the account belongs to you, and you can take a withdrawal for any reason. However, you must beware of the tax implications.
For any year in which a withdrawal is taken from a Sec. 529 college savings plan, the plan must issue a Form 1099-Q, "Payments from Qualified Education Programs," by February 1 of the following year. If the withdrawal payment is made to the Sec. 529 account beneficiary or the college for the benefit of the beneficiary, the 1099-Q comes to the beneficiary. If the payment is made out to you as the Sec. 529 account owner or plan participant, the 1099-Q comes to you. Either way, the IRS gets a copy and knows there was a withdrawal with possible tax consequences.
Form 1099-Q shows the total amount withdrawn from the Sec. 529 account during the year. Assuming the account made money, any withdrawal will include some basis from contributions and some earnings. Withdrawn basis amounts are always tax-free. That's because taxes were already paid on amounts contributed to the Sec. 529 account. Withdrawn earnings are tax-free when total withdrawals for the year don't exceed the account beneficiary's adjusted qualified education expenses.
The formula for calculating adjusted education expenses is tuition and related fees, plus,
Then subtract costs:
When withdrawals exceed adjusted qualified education expenses, all or part of the withdrawn earnings will be taxable. For many people, this can be an unpleasant surprise.
Here's an example to show how this formula works: Sam has $45,000 of college expenses. She receives $30,000 in tax-free scholarships and tuition discounts, so her adjusted qualified education expenses are only $15,000.
Sam's parents take a $45,000 withdrawal from her Sec. 529 account, which includes $6,000 in earnings. They use the money to cover the $15,000 of adjusted qualified education expenses, plus transportation costs, pizza and other incidentals. They also use the money to buy Sam a car to reward her for all the free money she earned.
Because the $15,000 of adjusted qualified education expenses is only one-third of the Sec. 529 account withdrawal, only one-third of the withdrawn earnings ($2,000) is tax free. The remaining $4,000 is taxable and should be reported as income on Sam's individual tax return. The tax hit on the $4,000 may be little or nothing — or it may be heavy — depending on her tax situation.
In situations where the child will bear the tax consequences, you can simplify reporting issues with the IRS by having the withdrawal check made out in the child's name. Then have the child sign it over to you, so you can control the spending. Better yet, have the check issued directly to the college for the benefit of your child. Either way, your child will get the 1099-Q, which will keep things straight with the IRS.
As you can see, the federal income tax treatment of Sec. 529 account withdrawals isn't necessarily simple. Contact your tax advisor if you have questions or want more information.
Section 529 college savings plans are set up for a specific account beneficiary, usually a child or grandchild. If you funded a Sec. 529 account with your own money, you can change the account beneficiary at any time. This may be helpful if a child decides to forego higher education or receives a full-ride scholarship.
This ability to change beneficiaries is also useful in other situations. For example, suppose your firstborn had a balance remaining in his or her Sec. 529 account after graduation. You can switch the name on that account to a younger sibling (or cousin) who plans to attend college in the future. Then you can take tax-free withdrawals from the account to cover the new beneficiary's adjusted qualified education expenses (see main article).
If you funded the Sec. 529 account with your own money, you're free to change the account beneficiary to yourself. Then you can take tax-free withdrawals to cover your own adjusted qualified education expenses if you decide to go back to school.
Withdrawn basis amounts are always tax free. However, withdrawn earnings used for purposes other than adjusted qualified education expenses will be taxable. They may also be hit with a 10% penalty. Contact your tax advisor for more information.
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