Non-qualified withdrawal from NY 529 plan - need help understanding some entries

[dyons]

For various reasons and after careful thought, I have decided to close down a NY State 529 plan account I have for my child. I have been funding it from 2008 to 2021 for the full amount ($10,000) each year to benefit from the NY state tax deduction (married filing jointly).

Having taken these tax deductions, I do understand that NY State will recover ("recapture") any tax benefits I've received for these deductions from this non-qualified withdrawal as well as tax me on the earnings. 

I am using TurboTax 2023 to do a WHAT IF calculation pretending that I withdrew the following amount in 2023.

Amount withdrawn: $26,000
Earnings: $4,000
Basis: $22,000

The Federal portion of the calculation is easy to follow. The earnings of $4000 is added to my income and there is an added penalty of 10% on this.

However, I am having difficulty understanding the NY State calculation shown by TurboTax. I'll use the line numbers of the NY State tax form IT-201 to explain my confusion.

New York additions:
Line 22 (NY 529 college savings plan distribution): $26,000

NY subtractions
Line 30 (NY 529 college savings program deductions/earnings): $4,000

I think I understand Line 30, the NY subtraction from the carried-over Federal income. This removes from NY income the part that was already brought over from the Federal return, which includes this amount as addition to federal income. To have retained it would tax me twice on the same amount. Is my understanding of the Line 30 entry correct?

However, I don't understand Line 22, the NY addition. Why I am being taxed for the full amount withdrawn - is the basis (principal) also being taxed by NY State?

I should mention that I looked at the TT generated NY 529 College Savings Program Worksheet (which is used to populate line 22) and entered in Part II, line 3a $190,000/- as my total contributions to the 529 program from 2008 to 2021, and for which I took a NYS deduction each of those years. I did NOT have ANY non-qualified withdrawals in that period. (This will be my first and only non-qualified withdrawal.)

Please can someone explain the logic used in the worksheet to populate line 22?

Many thanks in advance.

[NCperson]

@dyons if you received a tax deduction from NY over time ($10,000 per year), it would appear the $22,000 (netting the two lines together) is the recapture so it is now taxable to you.  Does the $4000 of earnings appear on line 16, carried over from the federal return?  

[dyons]

Thanks for your response and query. I used the TurboTax interview to fill in the 1099-Q, with the numbers I provided and me as the one to whom the distribution is made.

I, too, find $4000 on line 16, because it is taken directly from the federal return to get the Federal AGI, which is then modified by the NY additions and subtractions.

If your program does not give you any entries for lines 22 and 30, it seems as if NY tax is not recovering or clawing back any benefits I derived from getting 10K deductions each year between 2008 and 2021. So, could it be that TaxSlayer is not accounting for NY 529 nonqualified distributions properly?

Thanks for your response.

[NCperson]

@dyons sorry - I edited my original response as I mis read your query originally.  please re-read.  Isn't the net $22,000 the recapture and is taxable to you in NYS. 

[dyons]

Yes, line 16 carries over correctly from the federal return.

I can't understand the sentence "@dyons if you received a tax deduction from NY over time ($10,000 per year), it would appear the $22,000 (netting the two lines together) is the recapture so it is now taxable to you.  "

Please could you explain very slowly for someone who is not financially savvy. I contributed 190K over a period, which I deducted from my NYS taxes. I took out a lot of qualifying withdrawals from those contributions (plus earnings). I have heard it explained that tax free distributions increase the basis by the amount of the earnings portion of each qualified withdrawal. But I can't understand how to get to 22000 (beyond the fact that it adds 20,000, the current basis, and the 2000, the current earnings.

What is the connection of these numbers with the NY deductions I've taken, whose effects must be "clawed back"?.

As you can see, I'm very confused :(

Any help would be appreciated. Much thanks.

[NCperson · Accepted solution]

@dyons I can't see how you completed the NYS worksheet, but let me try and explain this way.

1) You were able to deduct $10,000 per year from your NYS tax return for contributions to the 529 plan.  That occurred under the presumption that eventually that money would be used for your child's college education.

2) to the extent that you did indeed use the money for college education, there was no tax to be paid (federal or state) when you withdrew the money from the 529 plan. 

3) but when you withdraw the money for non-educational purposes, which is what you state occurred, what was tax deductible (the $10,000 per year) now is reversed and is taxable to you.  

4) You withdrew $26,000 of which $4000 was the earning component.  Federal tax return shows that and that carries to Line 16 on the State Return.

5) now we have to deal with the remaining $22,000.  You got the benefit of $10,000 per year as a deduction in return for the promise that the money would eventually be used for college education.  Since that promise was compromised, NY State is simply reversing the benefit and saying, you took $22,000 in deductions years ago, well, now that is being reversed and it is $22,000 of income.   It is presented as an ADD of $26,000 on Line 22 and then a SUBTRACT of $4,000 on Line 30, the net being the $22,000.  

6) Showing the $22,000 as income to you is the 'clawback' for the deduction you took years ago.

7) NYS is showing this in 3 pieces but if you add it all together it is correct:  $4,000 ADDED on Line 16, $4000 SUBTRACTED on Line 30 and then $26,000 ADDED on line 22; the net of all three is $26,000 which is what you withdrew from the 529 plan - it is all taxable in NYS to you.

does that help? 

[dyons]

YES, THANK YOU!!!!! You have explained it VERY clearly indeed.

May I trouble you with a related question? If I have the non-qualified distribution sent to myself, it will, of course, be taxed at my current tax bracket. However, if I have it sent to my child, the tax is considerably less. 

I have done a WHAT IF for my child's taxes and added the distribution to her income by having the 1099-Q sent to her as the beneficiary. I notice that she is only taxed on the earnings ($4000) for both federal and NYS, with an additional 10% penalty for the former. 

However, on my return, Line 16 is blank (so I'm not taxed on the earnings) but Line 22 (NYS additions for NYS 529 distributions) is $26000. And Line 30 (NY subtractions - NYS 529 distribution earnings) is now zero.

Thus, it appears that I am taxed by NYS on both the remaining basis (22K) plus earnings (4K) making a total of 26K of additional income, but my child is ALSO taxed on the 4K of earnings. That is, the earnings portion are taxed twice - once for her and once for me.

What is the rationale for this double taxation, assuming that the program is behaving correctly?

Thanks again. Your help is much appreciated.

[NCperson]

@dyons  you are the owner of the 529 plan; why would the administrators send you a form with your dependent's social security number on it under this circumstance? 

I believe the way it works is if the money is sent to the college directly, the dependent's SSN is used on the 1099-Q when issued.  if the money is sent to you, your SSN is issued.  I am not aware that a 529 plan would send money directly to the beneficiary and use the beneficiary's SSN on the form. 

Don't take this the wrong way, but for your dependent to report income that was really yours to circumvent the tax is a form of fraud to me.  The rule is that if you do not use the money for educational purposes and withdraw the money, the OWNER of the 529 is responsible to report the related income. 

[dyons]

Thank you for your response, @NCperson. The idea of sending proceeds of any withdrawals, either qualified or non-qualified, to the beneficiary (my child) of an account by the account owner (me) is allowed by the NYSaves 529 program - and indeed any 529 program. The 1099-Q is addressed to me (with my SSN) for cases where I request the withdrawal proceeds to be sent to me and with my beneficiary's SSN when the proceeds are sent directly to her (for book purchases, for example) or if sent directly to the school (for tuition say). I have used all these ways to withdraw funds.

In fact, NYSaves 529 website allows these two options (account owner or beneficiary) ***even for non-qualified withdrawals.*** Please see under "Making withdrawals - How do I make withdrawals from the plan" at: FAQs: Managing your account | NY 529 Direct Plan (nysaves.org)

where the relevant excerpt reads (my emphasis added):

"All other withdrawals (i.e. ****nonqualified withdrawals****) can be sent to:

• The account owner.
• ****The beneficiary.****"

I tried to get a screen shot inserted for your convenience but was unable to do so.

I will also send you other links from web sources and indeed TurboTax community responses which say that a closed out 529's proceeds can be sent to the beneficiary to avail of that person's presumably lower tax rates. Please give me a bit of time to find these links for sources, as I have hundreds of tabs open.

Thus, I was doing a WHAT IF based on what I read, including the NYSaves rules linked to and excerpted above.

If you agree that this is indeed legally possible, I wonder if I could ask you to have a look at my preceding message and see if there is an answer to my question about the potential double taxation in the example.

Note that NY State is not being cheated out of the taxes. I am paying taxes on the full withdrawal and my daughter (beneficiary of the 529) is paying taxes on the earnings and the 10% federal penalty. But we seem to be double taxed on the earnings portion.

Thanks again for your thoughtful and cautionary response.

[NCperson]

On the WHAT IF... how are you completing the NYS worksheet? Sounds like you child is receiving $4000 and you are now only receiving $22000.... did you redo the worksheet prior to the WHAT IF? 

[dyons]

I redid the WHAT IF as follows: I changed the 1099-Q so that the recipient is my 529 account beneficiary (daughter).

That caused all of the following changes

ME

Federal: There are no amounts anywhere related to the distribution.

NY State: 

The Federal AGI carries over to NYS, which has nothing related to the distribution

Line 22 (NY additions): 26,000 (did you want to see the worksheet data for this?)

Line 30: 0

Thus, I have 26000 added to my NY taxable income (this is the 20000 basis plus 4000 earnings).

(In essence, I am still paying the same tax to NYS as I would if I had made myself the recipient of the 529 non-qual withdrawal. Therefore, NYS is getting the same from me independent of who the money is sent to.)

DAUGHTER

Federal: Fed Sched 1 line 8z includes the earnings 4000 from the 1099-Q. Sched 2 (via Form 5329) includes the 10% penalty on these earnings, which is added to the Fed tax total.

NY State:

Fed AGI (including the 4K earnings on line 16) carries over.

Line 22 (NY addition): blank

Line 30 (NY subtraction): 4158

Therefore, NYS does not seem to tax my daughter for the earnings as Line 16 is reduced by Line 30.

I think I may have answered my original question/concern. The earnings are not taxed twice - once in my return and once in my daughter's.

But a new concern emerges as it seems that NYS does not tax my daughter for ANY part of the non-qual withdrawal. And, I am taxed by NYS on the full amount of the non-qualified withdrawal (basis plus earnings). 

Perhaps the way the two returns are coupled ensures that NYS is satisfied that the tax on my return takes care of the distribution. But how would they know?

Does the way I have done the WHAT IF and the way the TT program has worked make sense to you? I want to be sure I have done it properly both legally and from a "technical" perspective using the TT program properly.

Many thanks for your response.

[dyons]

Hello @NCperson 

I don't want to be a bother, but could you please look at my last message immediately above and give me your opinion on the points it raises. I am particularly interested in whether you still feel the same as when you wrote in response to an earlier message of my solution: "Don't take this the wrong way, but for your dependent to report income that was really yours to circumvent the tax is a form of fraud to me."

Thanks again.

[NCperson]

@dyons - in your assumptions and worksheet, and I don't know how the worksheet if completed, if your daughter is reporting the $4,000, why aren't you just reporting $22,000 on your worksheet? 

<<Line 22 (NY additions): 26,000 (did you want to see the worksheet data for this?)>>

it is possible that there is no income tax for your daughter, if her taxable income is low enough.

Also, will your daughter have other taxable income?  One thing to consider is the "kiddie tax".  If her TOTAL income exceeds $15,050 in 2024 and her unearned income exceeds $2600 (which it would due to the $4,000), her tax rate is subject to your tax rate under kiddie tax rules.  This is FEDERAL

let's not worry about whether you can technically move the income to your daughter.  I have looked at the IRS website and can't find a reference to whether it is permitted or not permitted.  I know the 529 plan say you can have the distribution sent to the child, but it doesn't state whose SSN they will use if it is a non-qualified distribution. 

[dyons]

Apologies for the delay in following up to your question, @NCperson 

I did not actually fill out the worksheet. I simply changed the 1099-Q to have the recipient be my daughter and the Turbotax program automatically prepared the worksheets and the returns with the numbers I indicated. The program attributed 4000 earnings to my daughter and the full 26000 to me in the manner shown.

Are you suggesting that I should manually override the program to attribute 22000/- to me?

And, no, my daughter has other income and is not going to be hit with the kiddie tax. Her tax increases are just the tax on the earnings and penalty on it in the Federal return and nothing on the State return.

Have you other issues you can identify?

Thanks, again.