How College 529 Savings Account Withdrawals Are Taxed & Why You May NOT Want to Use a 529 Plan Altogether
Section 529 college savings plans have been around long enough that withdrawals are now commonplace.
You may be ready to take one.
The big advantage of 529 plans is that qualified withdrawals are always federal-income-tax-free—and usually state income-tax-free too.
What you may not know is that not all 529 withdrawals are tax-free qualified withdrawals, even in years when you have heavy college costs.
This article explains what we think are the six most important things to know about 529 withdrawals. Here goes.
Point No. 1: You Usually Have Several Payment Options
Say you are the 529 account owner or plan participant. Plans commonly use both terms to describe the person who established and controls the account. In this article, we will use account owner.
As the account owner, you can generally have a withdrawal check cut in your own name or have an electronic deposit made into your own account.
Alternatively, you can have a withdrawal issued in the name of the account beneficiary (the college student for whom you set up the 529 account, usually a child or grandchild) or issued directly to the educational institution for the benefit of the account beneficiary.
You choose your payment option by submitting a withdrawal request to the 529 plan.
Point No. 2: Watch Out for Withdrawals from 529 Accounts Funded with Custodial Account Money
Say you funded the 529 account with money that came from a custodial account that was set up for the account beneficiary—your child or grandchild—under your state’s Uniform Gift to Minors Act (UGMA) or Uniform Transfer to Minors Act (UTMA).
In this situation, you must use any money taken from the custodial account for the benefit of the child or grandchild.
You can’t take a 529 account withdrawal for yourself if the 529 account was funded with money from a child’s or grandchild’s custodial account. Because the money in the 529 account came from the custodial account, the 529 account money legally belongs to your child or grandchild, not you.
On the other hand, if you funded the 529 account with your own money, the money in the account is fair game. You can take withdrawals and do whatever you want with them—subject to the potential federal income tax implications explained later.
Point No. 3: The IRS Knows about Withdrawals
For any year that a 529 withdrawal is taken, the plan must issue a Form 1099-Q, Payments From Qualified Education Programs (Under Sections 529 and 530), 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.
Line 1 of Form 1099-Q shows the total amount withdrawn from the 529 account during the year. Assuming the account was worth more than the total contributions (i.e., the account made money), each withdrawal includes some earnings and some tax-free basis from contributions.
Withdrawn earnings are shown on line 2 of the 1099-Q.
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 percent penalty tax.
Withdrawn basis amounts are shown on line 3 of Form 1099-Q, and they are always tax-free and penalty-free.
Point No. 4: Withdrawals May Be Taxable Even in Years When Substantial College Costs Are Incurred
When the Form 1099-Q shows withdrawn earnings, the IRS becomes interested in the 1099-Q recipient’s Form 1040 because some or all of the earnings might be taxable. Here’s the deal on that.
Withdrawn earnings are always federal-income-tax-free and penalty-free when total withdrawals for the year do not exceed what the IRS calls the account beneficiary’s adjusted qualified education expenses, or AQEE, for the year.(1)
AQEE equals the sum of the 529 account beneficiary’s (2)
- 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. (3)
According to the IRS, tax-free educational assistance includes costs covered by (4)
- tax-free Pell grants;
- tax-free scholarships, fellowships, and tuition discounts;
- tax-free veterans’ educational assistance;
- an employer’s tax-free educational assistance program under Internal Revenue Code Section 127; and
- any other tax-free educational assistance (other than assistance received in the form of a gift or an inheritance).
In addition, tax-free educational assistance includes any costs used to claim the American Opportunity tax credit or the Lifetime Learning tax credit.
Key point. You can also include in AQEE (5)
- up to $10,000 annually for the account beneficiary’s K-12 tuition costs;
- the account beneficiary’s fees, books, supplies, and equipment required to participate in a registered apprenticeship program; and
- interest and principal payments on qualified student loan debt owed by the account beneficiary or a sibling of the account beneficiary—subject to a $10,000 lifetime limit.
Bottom line. When withdrawals during the year exceed AQEE for the year, all or part of the withdrawn earnings will be taxable. When withdrawals don’t exceed AQEE, all the withdrawn earnings are federal-income-tax-free.
Example 1. Withdrawal is partly taxable.
Your daughter’s 2021 college expenses total $45,000.
She received $30,000 in tax-free scholarships and tuition discounts, so her AQEE for the year is only $15,000 ($45,000 -$30,000).
Your daughter is the beneficiary of a 529 college savings plan account that you set up years ago. In 2021, you arrange for a $45,000 withdrawal, which consists of $9,000 of earnings and $36,000 of basis. You use the money:
- to cover your daughter’s $15,000 of AQEE;
- plus transportation expenses and other incidentals;
- plus a spring break vacation for her;
- plus a car for her because you’re so happy about all the free money she received.
The $15,000 of AQEE is only one-third of the withdrawn amount. Therefore, only one-third of the $9,000 in withdrawn earnings, or $3,000, is federal-income-tax-free. The remaining $6,000 of earnings ($9,000 – $3,000) is taxable and should be reported as miscellaneous income on your daughter’s 2021 Form 1040.
The entire $36,000 of withdrawn basis is tax-free.
Depending on your daughter’s overall tax situation and whether the dreaded kiddie tax applies to her, the federal income tax hit on the $6,000 may or may not be significant. (The $6,000 counts as unearned inco for kiddie tax purposes.)
Point No. 5: When You Keep a Withdrawal, There Are Tax Consequences
Assuming the 529 account was funded with your own money (as opposed to money from a custodial account), you are free to change the 529 account beneficiary to yourself and then take federal-income-tax-free withdrawals to cover your own AQEE if you decide to go back to schoo1. (6)
But if you take a withdrawal that you use for purposes other than education, report the taxable portion of any related account earnings as miscellaneous income on your Form 1040. Taxable amounts may also get hit with a 10 percent penalty tax to boot (see below).
Finally, if you liquidate a loser 529 account (worth less than the total amount of contributions), there are no federal income tax consequences .7 (The government stopped participating in your losses for tax years 2018-2025.)
Example 2. Income tax hit when you keep a withdrawal.
Assume the same basic facts as in Example 1, except this time your daughter’s tax-free scholarships and tuition discounts cover all $45,000 of her 2021 college expenses. Therefore, her AQEE for the year is zero.
Because one year of college was paid for with free money, you as the 529 account owner decide to take $45,000 out of the account to buy a new pickup truck for yourself. Fair enough! Who are we to judge?
Since your daughter (the account beneficiary) has no AQEE for the year, the entire $9,000 of earnings is taxable and apparently should be reported as miscellaneous income on your 2021 Form 1040.
Caveat. In this situation, it’s not entirely clear that you, as opposed to your daughter, are the one who must report the $9,000 as taxable income. But somebody has to do it, and it seems only fair that it should be you, since you spent the money on yourself.
Presumably, the IRS is not going to object as long as somebody reports the $9,000.
Point No. 6: Withdrawals Not Used for Education Can Also Be Hit with a 10 Percent Penalty Tax
As we explained earlier, some or all of the earnings included in a 529 withdrawal taken during the year must be included in gross income when the withdrawals exceed the account beneficiary’s AQEE for the year. But there’s more.
According to the general rule, the taxable amount of earnings is also hit with a 10 percent penalty tax. (8)
But the 10 percent penalty tax doesn’t apply to earnings that are taxable only because the account beneficiary’s AQEE was reduced by (9)
- tax-free Pell grants;
- tax-free scholarships, fellowships, and tuition discounts;
- tax-free veterans’ educational assistance;
- tax-free employer-provided educational assistance;
- any other tax-free educational assistance; or
- costs used to claim the American Opportunity or Lifetime Learning tax credit.
In addition, the 10 percent penalty tax doesn’t apply to earnings withdrawn when the account beneficiary attends one of the U.S. military academies (such as West Point, Annapolis, or the Air Force Academy). (10)
Finally, the 10 percent penalty tax doesn’t apply to earnings withdrawn after the account beneficiary dies or becomes disabled.”
Calculate the 10 percent penalty tax, if any, on IRS Form 5329, Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts, and include the penalty tax on the appropriate line of Form 1040. (12)
Example 3. Penalty tax when you keep a withdrawal.
Assume the same facts as in Example 2. You don’t owe the 10 percent penalty tax on the $9,000 of earnings because those earnings were only taxable due to your daughter (the account beneficiary) receiving $45,000 in tax-free scholarships and tuition discounts.
Variation. Now assume that your daughter joins a weird cult and decides not to attend college. You are totally disgusted with her, so you simply liquidate her 529 account and use the money to put in an expensive swimming pool and cabana to make yourself feel better. Your spouse approves.
Assume the liquidating withdrawal includes $27,000 of earnings. You must report the $27,000 as miscellaneous income on your Form 1040. In addition, you’ll owe the 10 percent penalty tax on the $27,000 ($2,700). Rats! But at least you got your money back. It could have been worse.
Don’t go to sleep on your Section 529 plan. Maybe, don’t use a 529 plan altogether.
The last thing you ever want to see on your tax return is a surprise. It’s hard enough when you know what’s coming. But surprise taxes and penalties are downright unpleasant.
The first thing to remember is that Section 529 withdrawals are not as simple as you would like them to be. You need to pay attention to your basis, your earnings, and what you (or your student) receive in funding from other sources.
While 529 Plans may be a good college savings solution for some families, for most we recommend that you consider alternatives. Self-directing a Coverdale plan, hiring your kids to work for your family business, purchasing income property and using life insurance are among them, but there are many others. Our website is loaded with articles, podcasts and more on this topic. Check it out by clicking on this link: https://lifetimeparadigm.com/?s=college
1 IRS Pub. 970, Tax Benefits for Education (2020), dated Jan. 21, 2021.
2 IRC Section 529(e)(3)(A).
4 IRC Section 529(c)(3)(B)(iv); IRS Pub. 970, Tax Benefits for Education (2020), dated Jan. 21, 2021.
5 IRC Sections 529(c)(7); 529(c)(8); 529(c)(9); 529(e)(3)(A).
6 IRC Section 529(c)(3)(C)(ii); Prop. Reg. Section 1.529-3(c)(1).
7 Before the Tax Cuts and Jobs Act (TCJA), you could throw a 529 account loss into the miscellaneous itemized deduction pot and claim a write-off to the extent your total miscellaneous itemized deductions exceeded 2 percent of your adjusted gross income. Unfortunately, for 2018-2025, the TCJA suspended this type of itemized deduction.
8 IRC Section 529(c)(6).
9 See IRC Section 529(c)(6), via IRC Section 530(d)(4); IRS Pub. 970, Tax Benefits for Education (2020), dated Jan. 21, 2021.
10 See IRC Section 529(c)(6), via IRC Section 530(d)(4); IRS Pub. 970, Tax Benefits for Education (2020), dated Jan. 21, 2021.
11 See IRC Section 529(c)(6), via IRC Section 530(d)(4); IRS Pub. 970, Tax Benefits for Education (2020), dated Jan. 21, 2021.
12 IRS Form 5329, Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts (2020).
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