NY 529 non-qualified withdrawal and NYS reclaim of tax deduction

[DanJ6669]

My understanding is that if you make a non-qualified withdrawal from a NY 529 plan, you pay federal income taxes on the earnings portion of the amount withdrawn, and possibly a 10% penalty on that amount as well.  (In my case, the funds were withdrawn to match an academic scholarship that my daughter received, so there was no 10% penalty.) For NY state taxes, the state "reclaims" (or claws back) the state tax deduction that was received when the contribution was made. This is done by taking the amount reported on the federal return and adding it to the NY return on IT-201 line 16, subtracting that same amount on IT-201 line 30 as a subtraction, and adding the amount of the withdrawal on IT-201 line 22.  Do I have this much right?

If so, I have some questions:

(1) What if part of my contributions were not tax deductible?  For example, NYS only gives you a tax deduction of up to $10,000 per year.  What if I contributed $15,000 one year?  I should not have to pay a "clawback" tax on the amount that I never received a deduction on, right?  How is it determined whether my withdrawal is taken from the $10,000  tax-deductible portion, or the $5,000 non-deductible portion, and how do I represent that in TurboTax?

(2) Similarly, let's say I've made $50,000 in contributions over the years, and now my account has grown to $75,000.  If I take $50,000 in qualified withdrawals, I have now taken out as much as I put in and received a deduction for.  What if the remaining $25,000 is a non-qualified withdrawal.  Does NYS still issue a "clawback" tax on that amount?  If not, how is that represented?

(3) Now, what if I inherited a 529 account (from a grandparent) in addition to my own account?  Does the state do a "clawback" for the income tax deduction that the deceased received?  In other words, do I have to pay a penalty for a benefit that someone else received?  If not, again, how is it determined which "bucket" of funds the withdrawal comes from (the inherited bucket vs my bucket)?

Thank you in advance!

[MarilynG1]

If your 529 withdrawal was used for education expenses (including room and board, even if your student lives at home), you don't need to report the 1099-Q at all in your tax return.

Here's more info on Form 1099-Q and New York's 529 College Saving Plan. 

@DanJ6669 

[DanJ6669]

Thank you for the response, but I as I said in my post, my withdrawal is non-qualified.

[DanJ6669 · Accepted solution]

After doing more research, I think I finally came up with the answer to my own question. Posting here in case anyone else has the same question(s).

Regarding this:

(1) What if part of my contributions were not tax deductible?

(a) On the NY TurboTax return, under Adjustments to Federal Income -> New York 529 college savings ccount activity, it asks for any "529 Withdrawals Not Used for Education". As instructed, enter the total of all nonqualified withdrawals, including previous and the current year. This feeds into New York 529 College Savings Program Worksheet , Part II, Line 1. 

(b) It then says Enter Total New York 529 Contributions, Again, as instructed, enter the total of all contributions. This feeds into the same worksheet, Part II, Line 2. 

(c) Then it says "Enter your nonqualified withdrawals and contributions from your 1998 through 2023 New York returns.  However, what it is really asking for regarding the contributions is, enter the tax-deductible contributions made.  In other words, if in 2010, my wife and I contributed $15,000, we should report only $10,000 for that year (because that was the maximum amount that we got a deduction for).  This feeds into the same worksheet, Part II, Line 3. 

Now, on that worksheet, Line 4 results in the total excess contribution beyond what was tax deductible.  Line 5 adds in non-qualified withdrawals for previous years, resulting in Line 6.  This amount is subtracted from Line 1. So you get the total non-qualified withdrawals, minus the non-qualified withdrawals taken in previous years (resulting the non-qualified withdrawal amount for the current year), minus the excess contributions.  If you have more excess contributions than you have used, this amount is negative, and you report $0 additions on your NY return.  If this amount is positive, this is the amount of non-qualified withdrawals taken out for the current year beyond the excess contributions. You report this amount on IT-201 Line 22.

So the bottom line here is that New York allows you take back any contributions made without receiving a tax benefit as a non-qualified withdrawal without having to pay back a tax deduction. It is only after you have used up your non-deductible contributions that NY will reclaim the tax benefit that you received when making the contributions.

For the second question, I tried this in TurboTax using the above logic. I "pretended" to withdraw the entire value of the 529 plan as a non-qualified withdrawal.  Going through the above math, TurboTax subtracted the amount of "excess" contributions from the total, and then I reported the balance on my IT-201.  So the answer to the question is that for non-qualified withdrawals, you pay tax on everything except for the amount of original contributions that were not tax-deductible. That is, you pay tax both on your original contributions that were tax-deductible, the earnings from those contributions, and the earnings from the contributions that were not tax-deductible.

(3) I still do not know how to handle the situation if an account is inherited, as this does not seem to be defined anywhere.

[billm1123]

Hi DanJ6669

Thanks for explaining how to get TT NYS to do the correct math. I was thinking I had to use the fudge factor line (I forget which line that is on the form).

I am surprised in this conclusion " New York allows you take back any contributions made without receiving a tax benefit as a non-qualified withdrawal without having to pay back a tax deduction. It is only after you have used up your non-deductible contributions that NY will reclaim the tax benefit that you received when making the contributions."

I was trying for at least a pro-rated amount (contributions made with receiving a tax benefit / total contributions). Just because you made the numbers come out to meet that conclusion, is the conclusion really the correct one? Have you ever found the actual rules anywhere?

As for "account is inherited", I have seen that NYS wants clawback on that as well. From the 1099Q you do know basis vs gains, but unless you know how much the grandparent deducted vs total contributions, how would you make the calculations?

I have something similar. I took a non-qualified withdrawal in my child's name (she received the 1099Q). If I were to use your method (in her tax return), the "Enter Total New York 529 Contributions" and "Enter your ... [tax-deductible] contributions from your 1998 through 2023 New York returns" portions would be 0 since they are on my returns not hers. Should I enter my numbers?

[AmyC]

1. NY does require you to work through your records and report based on what you know. If you receive a distribution for which you did not take the deduction, it is not taxable. NY is taxing dollars not previously taxed. If you put money in and did not get to reduce your NY tax bill, then that money has been taxed so only earnings on that money would be taxable.
2. Inherited accounts are presumed to have been deducted from taxes, therefore, taxable unless you have the paperwork to prove otherwise.

 NYs 529 plan book states: For New York State taxpayers, Qualified Rollovers will be subject to New York State income taxes on the earnings portion, as well as the recapture of any previous New York State tax deductions taken for contributions to the Account. See Section 7. Important Tax Information—New York State Tax Information.

Then page 36, where section 7 simply says:

Because it is your responsibility to verify contributions, withdrawals, and transfers, it is important for you to keep all records, invoices, and other documents regarding your Account to support: • Expenses that you claim to be Qualified Higher Education Expenses, K–12 Tuition Expenses, Apprenticeship Program Expenses, or Qualified Loan Repayments. • Withdrawals because of the death or Disability of, or receipt of a Qualified Scholarship by, your Beneficiary. • The earnings component of and compliance with the timing requirements applicable to Qualified Rollovers. • The earnings component of contributions funded from Qualified U.S. Savings Bonds or education savings accounts. • Refunded Distributions.

@DanJ6669 

@billm1123  For your last question, remember, this is a big paperwork trail. If NY asks, you will provide the paperwork trail to show what is taxable or not. When you claim your daughter's distribution, determine what proof you have to support your argument.

[billm1123]

Thank AmyC

Fortunately in my case I am the account owner and have the paper trail.

I took 7 years of deductions based on contributions to my son's and daughters accounts. I was just trying to figure out how to account for the deducted contribution on my daughter's return, since the non-qual withdrawal was paid to her not to me.

Either I claim no deducted contribution (aka it was all to my son), the entire amount (aka it was all to my son), half the amount (aka half was to my son, half to my daughter), or whatever I decide belongs to her vs him.

[AmyC]

That is a convoluted paper trail. You don't have a clear path when you claim some and don't claim some for years. All you can do is work through what you feel good about being able to defend - if asked. Each situation is unique. You may have one child that is clearly getting a doctorate and one child your hoping gets into college or you may have two star students where half each makes sense. You just have to do your best with what you have and know. Make notes and add them into your tax folder.

@billm1123