529 Non-qualified withdrawal taxes

[GaryBr2]

My son has graduated college and I'm fortunate enough to have a 529 surplus.  I'm interested in withdrawing the balance of the account but want to make sure I understand the tax implications first.  It's my understanding the earnings portion will count as ordinary income with an additional 10% penalty.  For example, if the earnings portion is $40K then that amount is included with my other income to calculate my tax liability.  Once that number is known, an additional $4K (10% of $40K) is added to determine my total tax liability.  Is my thinking correct?

Thanks

Gary

[Bsch4477]

You are correct. You might consider rolling over the funds into a Roth IRA. 

[GaryBr2]

Thanks, that's just what I wanted to hear

[Hal_Al]

Q. Once that number is known, an additional $4K (10% of $40K) is added to determine my total tax liability.  Is my thinking correct?

A. Yes.  That's how a non qualified distribution is taxed.

There are other options for handling left over 529 money.  Roll over to an IRA is one, but there are restrictions.  You can't roll over the whole amount at once and there's a $35K max, over time. 

https://www.schwab.com/learn/story/529-to-roth-ira-rollovers-what-to-know

Changing the beneficiary to another family member is another frequently used technique. 

https://www.savingforcollege.com/article/how-to-transfer-529-plan-funds-to-a-sibling

[GaryBr2]

We're fortunate to have a surplus in my sons 529 from which we made a 529 conversion to his Roth account.  He has the required earned income, and we honored the limit of $7K.  We received a form 1099-Q for that distribution. I'm the account owner and he is the beneficiary and since my son is the recipient of this conversion, it seems that he has to file this with his taxes.  Since the 529 to Roth is a new program is it obvious in Turbotax how to account for this?  I'm only familiar with the 1099-Q in my name for qualified expenses.

Thanks,

Gary

[Hal_Al]

Q. Since the 529 to Roth is a new program is it obvious in TurboTax how to account for this? 

A. No. And they only recently discovered that it doesn't.  They're working on it. 

In the mean time, I believe this statement still applies:

Just don't enter the 1099-Q in TurboTax.  When the box 1 amount on form 1099-Q is fully covered by expenses, or ROLLED OVER to another qualified account, TurboTax will enter nothing about the 1099-Q on the actual tax forms. But, it will prepare a 1099-Q worksheet for your records (the work sheet isn't going to tell you anything that will help with an IRS inquiry).   

References:

1. On form 1099-Q, instructions to the recipient reads: "Nontaxable distributions from CESAs and QTPs are not required to be reported on your income tax return. You must determine the taxability of any distribution." 
2. IRS Pub 970 states: “Generally, distributions are tax free if they aren't more than the beneficiary's AQEE for the year. Don't report tax-free distributions (including qualifying rollovers) on your tax return”.

But, you need to be sure that you meet all the new rules:

• $7000 yearly limit
• Your 529 savings account must be open for over 15 years before funds can be rolled over into a Roth IRA. 
• It must be a trustee to trustee rollover (the trustee to trustee rollover box will be checked on the 1099-Q)

• the Roth IRA must be in the beneficiary’s name

• 529 contributions made within the preceding five years cannot be rolled over.

• Beneficiary must have earned income that year of at least the amount transferred

• $35K lifetime maximum (2024 is the 1st year that the Roth rollover is allowed, so this isn't an issue yet)