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krk3384
Level 2

529 Non-Qualified Withdrawal and Scholarships

My college student will graduate in May 2020 with a job starting thereafter. Due to scholarships, there is a good bit of money left in his 529. To reward him for his hard work, I'd like to do a non-qualified 529 distribution directly to him so he will have money for an emergency fund, a Roth IRA and some spending money. He should be in the 12% marginal tax bracket this year working about 6+months. 

 

So anything I need to watch out for as far as taxes. 

Q: Is the 10% penalty on this non-qualified distributions waived due to scholarships? I would make sure the earnings on the distribution does not exceed his scholarships this semester. I assume no penalty.

 

Q: Can I still claim him as a dependent since he is a college student for a semester?

1 Best answer

Accepted Solutions
Hal_Al
Level 15

529 Non-Qualified Withdrawal and Scholarships

In order to use the scholarship exception to the 10% penalty, the scholarship must have paid for tuition and other expenses in the same year as the 529 plan distribution. That is, you cannot count the scholarship amounts prior to 2020 to offset the penalty. Furthermore, the entire distribution must match the scholarship amounts, not just the earnings portion. See example.

 

Total qualified expenses (including room & board) less amounts paid by scholarship less amounts used to claim the Tuition credit equals the amount you can use to claim the earnings exclusion on the 1099-Q. 
Example:
  $10,000 in educational expenses(including room & board)

   -$3000 paid by tax free scholarship

   -$4000 used to claim the American Opportunity credit

 =$3000 Can be used against the 1099-Q (usually on the student’s return)

 

Box 1 of the 1099-Q is $5000

Box 2 is $600

3000/5000=60% of the earnings are tax free

60%x600= $360

You have $240 of taxable income (600-360) plus $24 (10%) penalty

______________________________________________________________________________

As to being a dependent in his  Graduation year:

If he/she was a student (under 24) for at least 5 months and lived with you for more than half the year, and did not provide more than 1/2 his own support for the whole year, you can still claim him.

The real question is who should be claiming him in this "transition" year to adulthood. You two have to agree on who is going to claim his exemption. Each should do their taxes both ways and see which way the family comes out best.  Even then, you have to meet the rules. The rule is that a child of a taxpayer can still be a “Qualifying Child” dependent, regardless of  his income, if:

  1. he is a full time student under 24 for at least 5 calendar months of the year (graduating in May usually means you meet the 5 month rule)
  2. he did not provide more than 1/2 his own support (scholarships are considered 3rd party support and not support provided by the student). 
  3. lived with the parent (including time away at school) for more than half the year

 

So, it usually hinges on  "Did he provide more than 1/2 his own support. If the 529 distribution is put into savings/investment it does count as support.

The support value of the home you provided is the fair market rental value of the home plus utilities & other expenses divided by the number of occupants. IRS Publication 501 on page 20 has a worksheet that can be used to help with the support calculation. See: http://www.irs.gov/pub/irs-pdf/p501.pdf

View solution in original post

5 Replies
Hal_Al
Level 15

529 Non-Qualified Withdrawal and Scholarships

In order to use the scholarship exception to the 10% penalty, the scholarship must have paid for tuition and other expenses in the same year as the 529 plan distribution. That is, you cannot count the scholarship amounts prior to 2020 to offset the penalty. Furthermore, the entire distribution must match the scholarship amounts, not just the earnings portion. See example.

 

Total qualified expenses (including room & board) less amounts paid by scholarship less amounts used to claim the Tuition credit equals the amount you can use to claim the earnings exclusion on the 1099-Q. 
Example:
  $10,000 in educational expenses(including room & board)

   -$3000 paid by tax free scholarship

   -$4000 used to claim the American Opportunity credit

 =$3000 Can be used against the 1099-Q (usually on the student’s return)

 

Box 1 of the 1099-Q is $5000

Box 2 is $600

3000/5000=60% of the earnings are tax free

60%x600= $360

You have $240 of taxable income (600-360) plus $24 (10%) penalty

______________________________________________________________________________

As to being a dependent in his  Graduation year:

If he/she was a student (under 24) for at least 5 months and lived with you for more than half the year, and did not provide more than 1/2 his own support for the whole year, you can still claim him.

The real question is who should be claiming him in this "transition" year to adulthood. You two have to agree on who is going to claim his exemption. Each should do their taxes both ways and see which way the family comes out best.  Even then, you have to meet the rules. The rule is that a child of a taxpayer can still be a “Qualifying Child” dependent, regardless of  his income, if:

  1. he is a full time student under 24 for at least 5 calendar months of the year (graduating in May usually means you meet the 5 month rule)
  2. he did not provide more than 1/2 his own support (scholarships are considered 3rd party support and not support provided by the student). 
  3. lived with the parent (including time away at school) for more than half the year

 

So, it usually hinges on  "Did he provide more than 1/2 his own support. If the 529 distribution is put into savings/investment it does count as support.

The support value of the home you provided is the fair market rental value of the home plus utilities & other expenses divided by the number of occupants. IRS Publication 501 on page 20 has a worksheet that can be used to help with the support calculation. See: http://www.irs.gov/pub/irs-pdf/p501.pdf

Carl
Level 15

529 Non-Qualified Withdrawal and Scholarships

Point of order here that was overlooked in the previous response.

so he will have money for an emergency fund, a Roth IRA

That money can not be included when figuring maximum contribution allowed for ROTH contributions. Contributions to a retirement account, be it ROTH or Traditional IRA, are based on "EARNED" income. Since the 529 distribution is not earned income, it can't be included when figuring the maximum allowed contribution to a ROTH or other retirement plan. Just be aware of this.

 

Rickey
Level 3

529 Non-Qualified Withdrawal and Scholarships

Good day,

 

I have heard there are different opinions on this subject from "Experts"ranging from “there is no time limit” to “you must withdraw the funds before your child graduates” to “the money must come out in the same calendar (tax) year the scholarship was received."

 

Example

 Peter J. Greco, CPA, founder and chief tax strategist at the CSI Group, believes you have more latitude when deciding when to take the scholarship distribution.

 

“Most believe and have written that the distribution must be made in the same year that the scholarship paid for the tuition expense,” Greco says. “However, IRS 970 is silent as to when the money must be withdrawn.

 

Since the student doesn't need the money now but will after she graduates, and of course will pay tax on the interest made  how would I do this on turbo tax program.  Withdrawl info  come from  on the  1099, so the question is where do i offset it with the scholarships  in turbo tax

Thanks

Hal_Al
Level 15

529 Non-Qualified Withdrawal and Scholarships

@Rickey 

Q. How would I do this on turbo tax program?

A. It can't be done using TurboTax online, because you have no educational expenses, 1098-T or scholarship info to enter.

 

Using the desktop/download versions, you would  have to use a workaround in the forms mode.  I haven't tried it, but I would think you would make an entry directly on line 6 of form 5239.

https://www.irs.gov/pub/irs-pdf/f5329.pdf

 

For others reading this, I should point out that Greco's full quote is "Most believe and have written that the distribution must be made in the same year that the scholarship paid for the tuition expense". “However, IRS 970 is silent as to when the money must be withdrawn. If Congress is trying to encourage 529 plans, then it makes good policy sense that the withdrawals can be made any time prior to graduation.

Reference: https://www.investopedia.com/news/penaltyfree-way-get-529-money-back/

 

Although IRS Publication 970 does not directly address the issue of  when the money must be withdrawn, for purposes of the penalty exception, it's clear that a "qualified distribution" must be made in the that year expenses were paid. 

Rickey
Level 3

529 Non-Qualified Withdrawal and Scholarships

Ok thanks.  
Really thanks.

 

That is exactly what I was looking for.

 

Rick

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