How Are 529 College Savings Account Withdrawals Taxed?
Section 529 college savings plans have been around a long time. So, now withdrawals are commonplace, if you are ready to make a withdrawal there are somethings you need to know first.
The big advantage of 529 plans is that qualified withdrawals are always federal-income-tax-free—and usually state income-tax-free too.
Here are the 6 things you may not know:
The six most important things to know about 529 withdrawals.
1: You Usually Have Several Payment Options
The plan uses terms like 529 account owner or plan participant. This basically refers to the same person the account owner.
As the account owner, you have the ability to make a withdrawal, either by good ole fashion paper check or a direct deposit.
Here is the plus side for your college aged beneficiary, funds can be issued them. This withdrawal can also be issued to the approved institution of the beneficiary.
You choose your payment option by submitting a withdrawal request to the 529 plan.
2: Watch Out for Withdrawals from 529 Accounts Funded with Custodial Account Money
If the 529 account is a custodial account the money can only be withdrawn by the beneficiary.
On the other hand, if you funded the 529 account with your own money, the money in the account is fair game—subject to the federal income tax implications.
3: The IRS Knows about Withdrawals
For any year that a 529 withdrawal is taken, the plan must issue a Form 1099-Q, by February 1 of the following year.
If the withdrawal goes to the 529 account beneficiary (your child or grandchild), the 1099-Q goes to him or her.
If the withdrawal goes to you as the account owner, the 1099-Q goes to you.
Either way, the IRS gets a copy, so the IRS knows what happened. (Enter ominous soundtrack here)
As you will soon see, withdrawn earnings may or may not be tax-free, and they may or may not be subject to a 10% penalty tax.
4: Withdrawals Can Be Taxable Even in Years When Substantial College Costs Are Incurred
When the Form 1099-Q shows withdrawn earnings, the IRS ears perk up. Now they want to know how the 1099-Q is being reported on the 1040 of the recipient.
Here’s the deal on that.
Withdrawn earnings are always federal-income-tax-free and penalty-free. When the total withdrawals for the year do not exceed the IRS’s adjusted qualified education expenses, or AQEE, for the year.
AQEE equals the sum of the 529 account beneficiary’s:
- College tuition and related fees
- Room and board (but only if the beneficiary carries at least half of a full-time course load);
- Required books, supplies, and equipment;
- Computer hardware and peripherals, software, and internet access costs; and ·
- Expenses for special needs services.
Next, you must subtract any federal-income-tax-free educational assistance to calculate the account beneficiary’s AQEE.
- According to the IRS, tax-free educational assistance includes costs covered by
- Pell grants
- Tax-free scholarships, fellowships, and tuition discounts;
- Veterans’ educational assistance;
- An employer’s tax-free educational assistance program
- Any other tax-free educational assistance, not including a gift or inheritance.
- In addition, educational assistance including costs used to claim the American Opportunity tax credit or the Lifetime Learning tax credit.
Something of Note: You can also include in AQEE
- Up to $10,000 annually for the account beneficiary’s K-12 tuition costs;
- The beneficiary’s fees, books, supplies, and equipment required to participate in a registered apprenticeship program;
- Interest and principal payments on qualified student loan owed by the beneficiary or a sibling of the beneficiary are subject to a $10,000 lifetime limit.
The good, the bad and the ugly: Withdrawals exceeding AQEE for the year, all or part of the withdrawn earnings will be taxable. Withdrawals that don’t exceed AQEE, all the withdrawn earnings are federal-income-tax-free.
5: When You Keep a Withdrawal, There Are Tax Consequences
If the account is funded with your own money, you are free to change the 529 account beneficiary to yourself. Then take federal-income-tax-free withdrawals to cover your own AQEE if you decide to go back to school. (yay! Get that degree!)
Taking a withdrawal, and not using it for educational purposes, must be reported as miscellaneous income. Taxable amounts also gets hit with a 10% penalty tax to boot. (Ouch!)
Finally, if you liquidate a loser 529 account, there are no federal income tax consequences.
6: Withdrawals Not Used for Education Can Be Hit with a 10% Penalty Tax
Money taken out that exceeds the AQEE is taxable income. I know, I Know, we already covered that. However, there’s more. The taxable amount of earnings is a 10% penalty tax.
Here’s the loophole (ish), the 10% penalty tax doesn’t apply to earnings because the account beneficiary’s AQEE are reduced by:
- Pell grants;
- Tax-free scholarships, fellowships, and tuition discounts;
- Veterans’ educational assistance;
- Employer-provided educational assistance;
- Any other tax-free educational assistance;
- Costs used to claim the American Opportunity or Lifetime Learning tax credit.
In addition, the 10% penalty tax doesn’t apply to earnings, not when the beneficiary attends a U.S. military academy.
Finally, the 10% penalty tax doesn’t apply to earnings withdrawn after the account beneficiary dies or becomes disabled.