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Cyber1001
Level 1

529 plan accidental withdrawal - tax and penalty implication

I talked to my son's 529 plan administrator about the recent withdrawal, and she told me that when I deposit the exact withdrawal amount back to my son's 529 plan (no time restriction), I will not incur any tax or penalty.  She told me that when I will get 1099-Q and I just have to say that I didn't use the money and put it right back.  I told her that I will be withdrawing the correct amount for my son's college tuition later in the year and she told me that won't have any impact.  I just want to check to see if it is really this simple that I have to do is just depositing the same amount back and there will be no tax or penalty.  I read online that depositing the amount back will be treated as new contribution and will incur tax and penalty, but the 529 plan administrator told me they are the experts dealing with 529 plan and to talk to them directly instead of reading misinformation online.    

1 Best answer

Accepted Solutions
Hal_Al
Level 15

529 plan accidental withdrawal - tax and penalty implication

@Cyber1001 said  "I read that if I claim for AOTC, I should subtract the amount of qualified expenses ($4000) that were used to calculate the AOTC "

That is basically correct.  But not exactly.  It means you may not "double dip", use the same expenses for both tax benefits.  But, room and board (board even if the student lives at home) are qualified expenses  for a 529 withdrawal. So, you usually don't have to use all your tuition for the 529.

 

Cyber1001 said "Otherwise, I might have to pay tax for the capital gain of the money withdrawn from 529 plan.  Is that correct?" 

Yes, but again not exactly.  A portion of the "earnings" (box 2 of the 1099-Q) may be taxable.  The earnings are taxed as ordinary income  (like interest), not at capital gains tax rates. 

 

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 (Total distribution) of the 1099-Q is $5000

Box 2 (earnings) is $2800

3000/5000=60% of the earnings are tax free; 40% are taxable

40% x 2800= $1120

You have $1120 of taxable income  

____________________________________________________________________________________________

Qualified Tuition Plans  (QTP 529 Plans) Distributions

General Discussion

It’s complicated.

For 529 plans, there is an “owner” (usually the parent), and a “beneficiary” (usually the student dependent). The "recipient" of the distribution can be either the owner or the beneficiary depending on who the money was sent to. When the money goes directly from the Qualified Tuition Plan (QTP) to the school, the student is the "recipient". The distribution will be reported on IRS form 1099-Q. 
The 1099-Q gets reported on the recipient's return.** The recipient's name & SS# will be on the 1099-Q.
Even though the 1099-Q is going on the student's return, the 1098-T should go on the parent's return, so you can claim the education credit. You can do this because he is your dependent.

You can and should claim the tuition credit before claiming the 529 plan earnings exclusion. The educational expenses he claims for the 1099-Q should be reduced by the amount of educational expenses you claim for the credit.
But be aware, you can not double dip. You cannot count the same tuition money, for the tuition credit,  that gets him an exclusion from the taxability of the earnings (interest) on the 529 plan. Since the credit is more generous; use as much of the tuition as is needed for the credit and the rest for the interest exclusion. Another special rule allows you to claim the tuition credit even though it was "his" money that paid the tuition.
In addition, there is another rule that says the 10% penalty is waived if he was unable to cover the 529 plan withdrawal with educational expenses either because he got scholarships or the expenses were used (by him or the parents) to claim the credits. He'll have to pay tax on the earnings, at his lower tax rate (subject to the “kiddie tax”), but not the penalty.

 

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 $2800

3000/5000=60% of the earnings are tax free; 40% are taxable

40% x 2800= $1120

You have $1120 of taxable income  

 

**Alternatively; you can just not report the 1099-Q, at all, if your student-beneficiary has sufficient educational expenses, including room & board (even if he lives at home) to cover the distribution. You would still have to do the math to see if there were enough expenses left over for you to claim the tuition credit. Again, you cannot double dip!  When the box 1 amount on form 1099-Q is fully covered by expenses, TurboTax will enter nothing about the 1099-Q on the actual tax forms. But, it will prepare a 1099-Q worksheet for your records, in case of an IRS inquiry.

On form 1099-Q, instructions to the recipient reads: "Nontaxable distributions from CESAs and QTPs are not required to be reported on your income tax return. You must determine the taxability of any distribution." 

***Another alternative is have the student report some of his scholarship as taxable income, to free up some expenses for the 1099-Q and/or tuition credit. Most people come out better having the scholarship taxable before the 529 earnings. 

View solution in original post

8 Replies
Hal_Al
Level 15

529 plan accidental withdrawal - tax and penalty implication

There is a 60 day time frame for putting the money back in the plan.  The plan administrator should know that. 

 

 If you missed the 60 day window, it probably doesn't matter. If you use the money for your my son's college tuition later in the same year, it qualifies as a qualified distribution.  The distribution can be taken early (or late), as long as it's used (spent) in the same calendar year. 

Cyber1001
Level 1

529 plan accidental withdrawal - tax and penalty implication

Thanks for confirming that all I have to do is to put the money back (within 60 days) to not incur the tax and the penalty.  I will withdraw a reduced amount of money later ($4000 less) for my son's college qualified expenses.  I read that if I claim for AOTC, I should subtract the amount of qualified expenses ($4000) that were used to calculate the AOTC .  Otherwise, I might have to pay tax for the capital gain of the money withdrawn from 529 plan.  Is that correct?   Just want to make sure that I withdraw the right amount of money from 529 plan to get the best tax benefit.  By the way, our income qualify for full AOTC.      

Hal_Al
Level 15

529 plan accidental withdrawal - tax and penalty implication

@Cyber1001 said  "I read that if I claim for AOTC, I should subtract the amount of qualified expenses ($4000) that were used to calculate the AOTC "

That is basically correct.  But not exactly.  It means you may not "double dip", use the same expenses for both tax benefits.  But, room and board (board even if the student lives at home) are qualified expenses  for a 529 withdrawal. So, you usually don't have to use all your tuition for the 529.

 

Cyber1001 said "Otherwise, I might have to pay tax for the capital gain of the money withdrawn from 529 plan.  Is that correct?" 

Yes, but again not exactly.  A portion of the "earnings" (box 2 of the 1099-Q) may be taxable.  The earnings are taxed as ordinary income  (like interest), not at capital gains tax rates. 

 

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 (Total distribution) of the 1099-Q is $5000

Box 2 (earnings) is $2800

3000/5000=60% of the earnings are tax free; 40% are taxable

40% x 2800= $1120

You have $1120 of taxable income  

____________________________________________________________________________________________

Qualified Tuition Plans  (QTP 529 Plans) Distributions

General Discussion

It’s complicated.

For 529 plans, there is an “owner” (usually the parent), and a “beneficiary” (usually the student dependent). The "recipient" of the distribution can be either the owner or the beneficiary depending on who the money was sent to. When the money goes directly from the Qualified Tuition Plan (QTP) to the school, the student is the "recipient". The distribution will be reported on IRS form 1099-Q. 
The 1099-Q gets reported on the recipient's return.** The recipient's name & SS# will be on the 1099-Q.
Even though the 1099-Q is going on the student's return, the 1098-T should go on the parent's return, so you can claim the education credit. You can do this because he is your dependent.

You can and should claim the tuition credit before claiming the 529 plan earnings exclusion. The educational expenses he claims for the 1099-Q should be reduced by the amount of educational expenses you claim for the credit.
But be aware, you can not double dip. You cannot count the same tuition money, for the tuition credit,  that gets him an exclusion from the taxability of the earnings (interest) on the 529 plan. Since the credit is more generous; use as much of the tuition as is needed for the credit and the rest for the interest exclusion. Another special rule allows you to claim the tuition credit even though it was "his" money that paid the tuition.
In addition, there is another rule that says the 10% penalty is waived if he was unable to cover the 529 plan withdrawal with educational expenses either because he got scholarships or the expenses were used (by him or the parents) to claim the credits. He'll have to pay tax on the earnings, at his lower tax rate (subject to the “kiddie tax”), but not the penalty.

 

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 $2800

3000/5000=60% of the earnings are tax free; 40% are taxable

40% x 2800= $1120

You have $1120 of taxable income  

 

**Alternatively; you can just not report the 1099-Q, at all, if your student-beneficiary has sufficient educational expenses, including room & board (even if he lives at home) to cover the distribution. You would still have to do the math to see if there were enough expenses left over for you to claim the tuition credit. Again, you cannot double dip!  When the box 1 amount on form 1099-Q is fully covered by expenses, TurboTax will enter nothing about the 1099-Q on the actual tax forms. But, it will prepare a 1099-Q worksheet for your records, in case of an IRS inquiry.

On form 1099-Q, instructions to the recipient reads: "Nontaxable distributions from CESAs and QTPs are not required to be reported on your income tax return. You must determine the taxability of any distribution." 

***Another alternative is have the student report some of his scholarship as taxable income, to free up some expenses for the 1099-Q and/or tuition credit. Most people come out better having the scholarship taxable before the 529 earnings. 

View solution in original post

Cyber1001
Level 1

529 plan accidental withdrawal - tax and penalty implication

@Hal_Al Thanks for such detailed response! In your scenario, if I only withdraw $3000 from my son's 529 plan, there should be no tax on the earnings.  I will have to file my tax return to claim for AOTC, and my son has to file his tax return for 1099-Q even though he doesn't have any income.  Is that right?  Also, I would like to confirm that non-qualified education expenses from a 529 account are expenses such as transportation, personal and miscellaneous expenses.  I would assume that tuition surcharge by some colleges is counted as tuition.  

Cyber1001
Level 1

529 plan accidental withdrawal - tax and penalty implication

@Hal_Al By the way, if I have the distribution from my son's 529 plan sent to me, I will then be the recipient of the distribution that gets reported on 1099-Q, right?  In that case, do I file my tax return for 1099-Q and to claim for AOTC as well?  Thanks!  

Hal_Al
Level 15

529 plan accidental withdrawal - tax and penalty implication

Q. If I only withdraw $3000 from my son's 529 plan, there should be no tax on the earnings.  I will have to file my tax return to claim for AOTC, and my son has to file his tax return for 1099-Q even though he doesn't have any income.  Is that right?

A. Yes, you would file for the AOTC, on your return.   Your son  could enter the 1099-Q in TT, but shouldn't. It just risks mistakes.  When the box 1 amount on form 1099-Q is fully covered by expenses, TurboTax will enter nothing about the 1099-Q on the actual tax forms.  On form 1099-Q, instructions to the recipient reads: "Nontaxable distributions from CESAs and QTPs are not required to be reported on your income tax return. You must determine the taxability of any distribution." 

 

Q.. Also, I would like to confirm that non-qualified education expenses from a 529 account are expenses such as transportation, personal and miscellaneous expenses. 

A.  Food and housing are qualified personal expenses, for a 529.  But not transportation, clothing entertainment and other personal stuff.

 

Q. I would assume that tuition surcharge by some colleges is counted as tuition. 

A. Yes, as would computers and software used for school. 

Hal_Al
Level 15

529 plan accidental withdrawal - tax and penalty implication

Q. f I have the distribution from my son's 529 plan sent to me, I will then be the recipient of the distribution that gets reported on 1099-Q, right?  In that case, do I file my tax return for 1099-Q and to claim for AOTC as well? 

 

A. Yes, the "recipient"  files the 1099-Q, if it needs to be filed, even if you are also claiming the AOTC.  But, in the $3000 example, you  would not need to file the 1099-Q because the box 1 amount is fully covered by expenses.  You already know none of it is taxable.

Cyber1001
Level 1

529 plan accidental withdrawal - tax and penalty implication

@Hal_Al Really appreciate all your help!  🙂

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