I have taken a nonqualified withdrawal from my child's 529 account under the scholarship exception. For federal taxes, I understand this means that I will pay federal tax on the earnings portion but no 10% penalty (because of the scholarship exception).
However, I am struggling with the state impact of this.
I understand that I will also pay a state tax on the earnings portion of the withdrawal.
The complication is with the triggering of a state recapture of deductions taken in the past for 529 contributions.
- If all of the principal in the 529 had gotten there through my own contributions for which I had taken state deductions, I understand that there would be a recapture of those deductions.
- If all of the principal in the 529 had gotten there through gifts from out-of-state grandparents for which nobody had taken state tax deductions, I understand that there would be no recapture (since there would be no deductions to recapture).
In my situation, contributions to the 529 were made in both ways: I contributed some and took state tax deductions for those. The child's out-of-state grandparents contributed some for which state tax deductions were never taken.
Looking online at the history of the 529 account, it is very clear when contributions were made as gifts (noted as such on the statements).
Let's say (using round numbers that are approximations)
- I made $20,000 in contributions and took corresponding state deduction for that $20K at various times over the past 20 years
- Gift contributions (for which no state tax deductions were taken) were made for about $60,000 over the years
- to date, $50,000 of the 529 has been used for qualified distributions (child is still a college student). Of this $50,000, the basis (non earnings portion) used for qualified distributions has been $25,000.
- After those qualified distributions had all come out of the account, I then withdrew $30,000 non qualified (due to the scholarship exception).
Of note: the principal/basis portion of the money withdrawn for qualified distributions ($25,000) is MORE THAN the $20,000 I originally took a state tax deduction for. Therefore, by the time I took the non-qualified $30,000 withdrawal, the account, though it still had money in it, was essentially emptied of my original contributions (the ones for which state tax deductions were taken). In effect, the only principal remaining in the account was from the gifts for which no state tax deductions were ever taken.
Therefore, there shouldn't be a recapture of any state tax deductions, right ? The $20K (for which state tax deductions were taken) was used for qualified purposes, and the gift contributions ended up being more than needed due to a scholarship, so a nonqual withdrawal was made. Is there a way to proceed accordingly (to not automatically trigger the state tax recapture)?
