I took an early withdrawal from my traditional ira. May I offset the 10% penalty with a 529 payment (60% principal and 40% earnings) for qualified education expenses.

[SweetieJean]

Are you also using the IRA to pay education expenses?

[Tykester66]

Yes.  The total qualified college expenses are greater than the ira withdrawal and 529 distribution combined

[Hal_Al · Accepted solution]

No, you may not count the same expenses for the 529 plan distribution and the IRA withdrawal penalty exception*. But, since you say that the total qualified college expenses are greater than the IRA withdrawal and 529 distribution combined, this should not be a problem in your case.

*For example, if you make a $10,000 529 withdrawal and a $10,000 IRA withdrawal and only paid $18,000 in expenses, you will have to decide how the allocate the the $18,000 between the two tax breaks.

It gets more complicated, as you are probably claiming one of the education credits. You may NOT count the same expenses for a 529 plan withdrawal that your count for a tuition credit. But, you MAY count the same expenses for the IRA penalty exception  that you count for a tuition credit.

[Tykester66]

Thanks.  I appreciate the answer.  In your example, if the 10k 529 withdrawal was 6k principal and 4k earnings, could I not cover the 18k expenses as: 10k ira withdrawal, 4k 529 earnings, and finally 4k of the 6k in principal?  In this way, i would owe no taxes.  Reminder - the 529 withdrawal was paid directly to the school.  Also - our income is too high to qualify for the education credits although we have filed for them in past years.

[Hal_Al]

No. It works this way*: you have a 10K 529 plan withdrawal but only 8K of qualifying expenses. This means that 80% (8,000/10,000) of the earnings is tax free, 0.80 x 4,000 = $3200. You have $800 (4000-3200) of taxable income.

"the 529 withdrawal was paid directly to the school" is important info. This means the withdrawal is reported on the student's return, not the parent's**. He/she will have $800 of income, not you. It is considered investment income and subject to the "kiddie tax".

*assuming you want to assign the 1st 10K of expenses to the IRA.

**For 529 plans, there is an “owner” (usually the parent), and a “beneficiary” (usually the student dependent). The "recipient" of the 1099-Q can be either the owner or the beneficiary depending on where the money was sent***. When the money goes directly from the 529 Plan  to the school, the student is the "recipient". The 1099-Q gets reported on the recipient's return. ***When you request a withdrawal from the plan, they usually give you three choices: 1. Send it to the owner (you), 2. Sent it to the beneficiary, or 3. Send it to the school.

[Tykester66]

Ok Great answer.  Really appreciated. Final Comment -

I'm my real word scenario, I have a 40k IRA withdrawal and 25k 529 withdrawals.  I know I can trace 30k of expenses out of my checking account for qualified education expenses which leaves 10k from the IRA in penalty.  Based on your answer above, I will not be able to apply any of the 529 withdrawals to cover this 10k this since the withdrawals are reported on my kids' returns. **Correct**?

In addition, the 529 withdrawals are fully qualified and as such there is no applicable kiddie tax.  **Correct**?

[Hal_Al]

The first part is correct, but not for that reason. Even if you had been the recipient of the 529 funds, instead of your kid, you could not "apply any of the 529 withdrawals to cover this 10k".

The 2nd part is not correct. The 529 withdrawals are not fully qualified. You have already used the entire $30K in expenses to avoid penalty on the first $30K of the IRA withdrawal. You cannot also apply those same expenses to the 529 withdrawal.  $10,000 (the 40% of the $25K due to earnings) from the 529 plan will also be subject to a 10% penalty in addition to the tax due on the 40%. The penalty is due because you don't meet one of the exceptions (tax free scholarships or claiming a tuition credit),

Room & board are qualified expenses for the IRA exception and 529 plan withdrawal, even though they are not qualified expenses for a education credit.

[Tykester66]

OK - I agree with your first part answer.  However, the information I think you're missing is that our total expenses were 55k (tuition, room&board, 2 kids in college).  Given this new information, I think you'll agree that there is no kiddie tax on the 25k from 529.

[Hal_Al]

That's correct. $30K of the $55K expenses is used for the IRA and $25K for the 529 plan. No kiddie tax or even regular tax is due
Alternatively, you could use $40K of the total $55k of expenses against the IRA withdrawal, totally eliminating the IRA penalty, and only $15K against the 529 distribution, making $4000 (40% of $10K [25-15=10]) subject to tax and penalty. Your original question was "May I offset the 10% IRA penalty with a 529 payment".  So, yes, sort of. You can  use the expenses that were paid for by the 529 plan to off set the IRA penalty, as long as you don't use the same expenses to claim the 529 plan earnings exclusion. It's probably not a good idea, as that portion of the 529 Plan distribution will be subject to a 10% penalty, in addition to the  tax. But the only way to be sure is  crunch the numbers to see which way you come out better.

[Tykester66]

Awesome.  You're certainly knowledgable.  Crunching the numbers, applying 10k of expenses to the IRA saves $1000.  Applying it to the 529 withdrawal only saves $400 (in my example).  I'm not sure I'd risk an audit over $600.   Thanks!

[dmertz]

Given the results, it seems that the distribution from the 529 plan consists largely of basis, perhaps somewhere between 80 and 90%.  If that's the case, allocating $10,000 of qualified higher education expense to the 529 plan distribution rather than the IRA distribution is less beneficial because it's being allocated to a distribution that is largely free of tax and penalty anyway.

[Hal_Al]

And your chances of audit do not go up by doing it that way. In fact, reporting 0 taxable income when you have a 1099-Q is more likely to generate an IRS inquiry (based on the frequent questions we've seen in this forum on that topic)

[Tykester66]

@dmertz Your reply made me re-think my math.  I was *not* including income tax on the excess 529 earnings in my calculation (only the penalty).  Once I include the excess 529 earnings as income and pay the income tax + 10% penalty, I would owe more tax than by applying all the expenses to the IRA distribution.  

Everyone's situation will vary, but in my case the break even point on the principal\earnings is ~74%.  Since mine is less than that, I'll pay less overall tax by using the *entire* 529 distribution against the actual expenses and the *remainder* of the expenses against the IRA withdrawal.

[Tykester66]

correction in first paragraph - "...than by applying all the expenses to the 529 distribution"