Non-Qualified Withdrawals Paid to Beneficiaries

[Curious One]

In 2023, I arranged for distributions to my children out of the remaining balance of their 529 accounts.  I sized the withdrawals taking account of their other income to minimize the tax impact.  Or so I thought.  Instead, in addition to the 10% penalty, TT is telling me that they are liable for 10% in income taxes even though they are inside of the first tax bracket.  No deduction for this income? 

In addition to that, it's asking for my income (taxable?  AGI?  MAGI?) and then making further adjustments to tax due on account of these withdrawals.  The kids were 21 or younger in 2023.  I'm guessing this has something to do with the kiddie tax?  And as to this, I will file an extension so don't actually know where my 2023 income will come out.  How do I handle this issue? 

Finally, is there a way to achieve what I sought by handling matters differently?

[KrisD15 · Accepted solution]

Since this was done in 2023, and you are now past the window to return the distributions to the accounts, there is nothing you can do but claim the income and pay the tax.

Yes, the dependent children are subject to Kiddie tax if they are under 18 or under 24 and a student.

If you can't complete the student's returns because you are extending your return, you'll need to extend their returns as well. Of course that just gives you more time to file, not free time for paying taxes. If a balance is due, the extension to file does not eliminate penalties and/or interest on the tax bill. 

Had you waited, the rules have changed for tax year 2024 where funds in a 529 account can be rolled over into a Roth account, but this change does not help you if you depleted the accounts in 2023. 

Community is open year-round. You can always ask a tax question BEFORE you make a financial transaction decision. 

[Hal_Al]

Q. TT is telling me that they are liable for 10% in income taxes even though they are inside of the first tax bracket.  No deduction for this income? 
A.  A dependent' standard deduction is only $1250 or his earned income + $400.  A taxable 529 distribution is unearned income, so he only gets a $1250 standard deduction, not the full $13,850. 

Q.   I'm guessing this has something to do with the kiddie tax?  How do I handle this issue? 

A. Yes, the kiddie tax applies. You'll need your info or a reasonable estimate.

Q. Is there a way to achieve what I sought by handling matters differently?

A. Sort of. You can spread it out over several years. You can also change the beneficiary to another family member. A new provision allows rolling the money to the beneficiary's  Roth IRA (in steps)

[Curious One]

Thanks to both respondents.  

A couple of follow up questions. 

Where does the kiddie tax liability get reported?  On whose return?  And does it make a difference to the amount owed under the kiddie tax?  Are there benefits to doing it one way or the other?

Consider if reported under parents' return on 8814, does that have the effect of increasing parent income?  Or only show that parents will be paying the child's kiddie tax liability?  If increasing parental income, does this flow through to AGI, MAGI, etc.?  

[Hal_Al]

Q. Where does the kiddie tax liability get reported?  On whose return? 

A. On the student's return, using form 8615*.

Q. And does it make a difference to the amount owed under the kiddie tax? 

A. Yes, as the parent's marginal rate is almost always more. The kiddie tax kicks in if he has more than $2500 of unearned income and net taxable income. 

Q. Are there benefits to doing it one way or the other?

A. It's not optional, but  no, in your case.

Q. Consider if reported under parents' return on 8814, does that have the effect of increasing parent income?  Or only show that parents will be paying the child's kiddie tax liability?  

A. Parents will be paying the child's kiddie tax liability

*If his only income is from interest and dividends, Alaska PFD or capital gains distributions shown on a 1099-DIV, there is a provision for entering his income  on your return, using form 8814.  Taxable 529 earnings or taxable scholarship doesn't qualify

[Curious One]

Where in TT do I enter parent data on child's return?  I started to do it because I was prompted to review and update the corresponding step-by-step item, but the prompt no longer appears and I can't remember which one it was.  Thank you.  

[Hal_Al]

Federal Taxes Tab

Wages and income

Scroll down to:

--less common income

---Child's Income (under 24)

[Curious One]

@Hal_Al 

@KrisD15 

I posted this earlier elsewhere within the community, but thought I'd seek your input considering how helpful both of you with my prior post:

The new rollover option with 529s is very compelling, but there remain many questions about how it can be used. A few such questions are raised in the balance of this note.

First, it was deemed okay to make a rollover in respect of the 2023 tax year so long as it was done after 1/1/24.  Is this an accurate reading of what’s permissible?  If not, and having already taken this action, am I able to reverse it within 2024 and what would I need to do?  Seek recoding to 2024 to the extent of earned income with the balance treated as non-qualified distribution?  Other options?  

Second, any such rollover is limited to an amount not greater than annual contribution limits. And as part of this, any rollovers are limited to total earned income if less than the annual contribution limits. However, as a rollover, it seems that it should not limit a further deposit to the Roth IRA in similar amounts.

Consider that a rollover is not a contribution, notwithstanding some of the quirks imposed on this type of rollover. As such, it seems to me that limiting contributions by virtue of having made a rollover is inconsistent with how this issue is treated in other circumstances where both are possible in the same year.

Is there anything specific in legislative history, IRS statements or elsewhere that mandates different treatment in this situation?

When first thinking about this issue, I had some other questions as well, but can't recall them at this point. Feel free to be expansive, going beyond the particulars of this post when addressing the topic.

[Hal_Al]

What "new rollover option with 529s" are you asking about? The ability to roll it over to a Roth IRA? Or are you asking about some  thing specific to your state?

I assume you're asking about a roll over to a Roth IRA.

Q. First, it was deemed okay to make a rollover in respect of the 2023 tax year so long as it was done after 1/1/24.  Is this an accurate reading of what’s permissible?

A. No. "In order for the rollover to be federal tax-free, it must be paid through a direct trustee-to-trustee transfer. In other words, you cannot first withdraw the amount to be rolled over and then contribute that amount to the Roth IRA. If you try to do this, you will end up with an unqualified withdrawal subject to tax and penalty."

"A new option for 529 plans is the ability to roll over funds to a Roth IRA tax-free and penalty-free starting January 1, 2024. This option is subject to certain conditions, including: 

• The 529 plan account must have been maintained for at least 15 years 
• The amount rolled over cannot exceed the total amount contributed to the 529 plan before the five years prior to the rollover 
• The rollover must be a direct rollover 
• The Roth IRA must be opened by the same beneficiary as the 529 plan 
• The rollover is subject to annual Roth IRA contribution limits, which are based on the beneficiary's income, not the parents' 

The lifetime limit for 529-to-Roth IRA rollovers is $35,000. 

Some say that it may be best to wait until later in 2024 to consider a 529-to-Roth IRA rollover, as the IRS and states may issue more guidance in the meantime."