recapture of 529plan contribution for nonqualified distribution (Virginia)?

[Anonymous]

Years ago, we made contributions to VA 529 accounts for our children and deducted those contributions on our Virginia tax returns. We ended up with money left over in the 529 accounts. In 2022, we took a $20k distribution from one of these accounts. There were no qualified educational expenses to offset the distribution, so we will pay income tax (and 10% federal penalty) on the gain. Virginia 529 reported the basis ($13k) and the gain ($7k) components of the distribution on a 1099-Q. Using TurboTax Premier desktop version, the gain is reported as taxable federal income in the federal interview section. In the Virginia state interview section, the gain is not excluded from Virginia taxable income (correctly, because there were no extenuating circumstances like death or disability of the beneficiary, etc). My question is whether and HOW to report the basis portion of the nonqualified distribution for recapture on the Virginia state income tax return. I am guessing we add the $13k back in Schedule ADJ "Additions to Income", "Other additions", code 99? Can't find any specific reference to this in Virginia's Form 760 Instructions.  It does reference Virginia ABLE account recapture, but not 529s.  Thanks!

[Hal_Al]

Q.  My question is whether and HOW to report the basis portion of the nonqualified distribution for recapture on the Virginia state income tax return. 

A. You don't report that at all.  That is, there is no adjustment on the VA return.

The taxable portion has been calculated on the federal return.  That amount transferred to the VA return with the federal AGI.  That is, the same amount is taxed on the VA return. There is no adjustment on the VA return.

Had you qualified for a penalty exception, on the federal return, there would be a subtraction adjustment on the VA return. 

[Anonymous]

Im all in favor of lower taxes, but since Virginia let me take the deduction for the contributions on past year's return (no Fed deduction, but did get state) and Virginia 529 website says nonqualified distributions subject to recapture by Virginia, seems like it'll catch up with me somewhere.  Only the gain is being accounted for in fed and state taxable income.  Is TT adding the basis (contribution) back somewhere behind the scenes in the TT calculations?

[Hal_Al]

I'm not specifically familiar with VA rules.  That said, I'm  not finding any reference to an add back of previously deducted 529 contributions in the VA form 760 instructions (https://www.tax.virginia.gov/sites/default/files/vatax-pdf/2022-760-instructions.pdf)

Although recapture is common in many states, there's usually a line, right on the tax form, for it.  

I do have the VA software and don't see a place to make that adjustment. 

[Anonymous]

@Hal_Al Agreed, no reference in Form 760 instructions.  No place for adjustment in TT unless you use

Income>Here's the Income that Virginia Handles Differently>Other Additions to Federal Income>choose Edit: "Enter a brief description and a total amount for any other addition to federal income you need to report in 2022 (these are not common.)" I would enter something like Recapture of prior 529 contribution deduction for nonqualifed distribution

In Forms, entering a description here populates Other Additions Statement, Code 99 Other Additions. 

In the paragraph below, I have copied and pasted what seems to be the applicable reference from the Code of Virginia.  Are there tax rules regarding taxable income that are 

• A: the state law, but
• B: the income in question is not required to be reported inasmuch as the state-published income tax preparation instructions does not address it and therefore
• C: rules are unenforced and the taxpayer need not report income??? I'd rather be safe than sorry but don't want to pay what I'm not required to.

From Code of Virginia Code of Virginia Code - Chapter 3. Income Tax, § 58.1-322.03. (Contingent expiration date — See Editor's note) Virginia taxable income; deductions, Section 7a (which deals with 529 contribution deductions)

Notwithstanding the statute of limitations on assessments contained in § 58.1-312, any deduction taken hereunder shall be subject to recapture in the taxable year or years in which distributions or refunds are made for any reason other than (i) to pay qualified higher education expenses, as defined in § 529 of the Internal Revenue Code or (ii) the beneficiary's death, disability, or receipt of a scholarship. For the purposes of this subdivision, "purchaser" or "contributor" means the person shown as such on the records of the Virginia College Savings Plan as of December 31 of the taxable year. In the case of a transfer of ownership of a prepaid tuition contract or college savings trust account, the transferee shall succeed to the transferor's tax attributes associated with a prepaid tuition contract or college savings trust account, including, but not limited to, carryover and recapture of deductions.

[Hal_Al]

Sorry, I don't have anything more to add. 

[Anonymous]

If helpful to other filers, here's what the Virginia Department of Taxation said in response to my question:

"The distribution should be reported on the 2022 Schedule ADJ under Additions using code 99 if it is not included in the Federal Adjusted Gross Income and attach a statement explaining the recapture of the 529 Virginia College Savings Plan. However, if it is included in the Federal Adjusted Gross Income, no further action needs to be taken."

[BrittanyS]

That is correct.  If the distribution is included in the federal income, there are no additional steps to take when entering into the TurboTax software.  If you do need to make the entry into the state return, you can follow these steps in TurboTax online:

1. Click State Return
2. Click Continue next to Virginia
3. Under "Here is how Virginia Treats your Income Differently" scroll down to Misc
4. Click Start next to Other Additions to Federal Income
5. Finish Interview questions to add the distribution income

@Anonymous 

[Anonymous]

@BrittanyS Agreed.  I think what's confusing is that the full distribution is RECORDED in the federal return, but only the gain is included in federal taxable income (as best I can tell).  Therefore the contribution basis, the part subject to recapture in VA, would need to be added in the Virginia return, or so it would appear to me.  Would you agree?

[BrittanyS]

No, you do not need to include the contribution basis in the VA return.  The tax and possible 10% penalty would only be subject to any gains reported.  Only the gains should be reported on the VA return.  For more information, see the link below:

Cashing out your 529

@Anonymous 

[Anonymous]

@BrittanyS  It's *almost* comical that I'm arguing so persistently for a tax I don't want to pay. But I've yet to be convinced by anything TT has offered by way of explanation. I didn't see anything in the link you referenced about Virginia's treatment of an unqualified distribution, only the federal treatment which I understand.

At savingforcollege.com:

INVEST529

VIRGINIA

"The principal portion of rollovers and nonqualified withdrawals from this plan are included in Virginia taxable income to the extent of prior Virginia tax deductions. Nonqualified withdrawals for this purpose do not include withdrawals made as the result of the beneficiary's death or disability or withdrawals made on account of the beneficiary's receipt of a scholarship."

What I read here is the PRINCIPAL PORTION (not just the gain) is to be INCLUDED in taxable income TO THE EXTENT OF PRIOR VIRGINIA TAX DEDUCTIONS ( we did take Virginia deductions in the year of contributions.)

By the way my caps are for emphasis but not shouting 😉; I'm very grateful for your time, expertise and consideration. I just haven't been convinced. 

[Hal_Al]

I, too, find wording, on the internet,  saying it's taxable:

"Non-Qualified Distributions Taxes, Penalties, Recapture

A non-qualified withdrawal from a Virginia 529 is subject to Virginia taxes on the full amount to recapture prior year tax deductions."  https://thecollegeinvestor.com/529-plan-guide/virginia/#t-1588535234267

Where I can't  find it, is in the VA tax form instructions or on the VA tax forms.  The fact that the VA tax people told you to use code 99 (the catch all) tells me it may not be so.   Every other state covers it, in the instructions, and even has a specific line, on the forms, for it.