The big advantage of 529 plans is that qualified withdrawals are always federal-income-tax-free, and usually state-income-tax-free too. Taxpayers should know that not all 529 withdrawals are tax-free qualified withdrawals, even in years when you have heavy college costs. As stated in part 1, there are six important points to know about 529 plan withdrawals. In this final part 2, we will highlight the last three of them.

4. Withdrawals May Be Taxable Even in Years When Substantial College Costs Are Incurred 

When the Form 1099-Q shows withdrawn earnings, the IRS is interested in the 1099-Q recipient’s Form 1040 because some or all the earnings might be taxable. Withdrawn earnings are always federal-income-tax-free and penalty-free when total withdrawals for the year do not exceed what the IRS calls the account beneficiary’s adjusted qualified education expenses, or AQEE, for the year. AQEE equals the sum of the 529 account beneficiary’s: 

  • college tuition and related fees;
  • room and board (but only if the beneficiary carries at least half of a full-time course load);
  • required books, supplies, and equipment;
  • computer hardware and peripherals, software, and internet access costs; and
  • expenses for special needs services.

 Next, you must subtract any federal-income-tax-free educational assistance to calculate the account beneficiary’s AQEE. As per the IRS, tax-free educational assistance includes costs covered by: 

  • tax-free Pell grants;
  • tax-free scholarships, fellowships, and tuition discounts;
  • tax-free veterans’ educational assistance;
  • an employer’s tax-free educational assistance program under Internal Revenue Code Section 127; and
  • any other tax-free educational assistance (other than assistance received in the form of a gift or an inheritance).

 Additionally, tax-free educational assistance includes any costs used to claim the American Opportunity tax credit or the Lifetime Learning tax credit. You can also include in AQEE: 

  • up to $10,000 annually for the account beneficiary’s K-12 tuition costs;
  • the account beneficiary’s fees, books, supplies, and equipment required to participate in a registered apprenticeship program; and
  • interest and principal payments on qualified student loan debt owed by the account beneficiary or a sibling of the account beneficiary—subject to a $10,000 lifetime limit.

 When withdrawals during the year exceed AQEE for the year, all or part of the withdrawn earnings will be taxable. When withdrawals don’t exceed AQEE, all the withdrawn earnings are federal-income-tax-free. 

5. There Are Tax Consequences When You Keep a Withdrawal 

Assuming the 529 account was funded with your own money, as opposed to money from a custodial account, you are free to change the 529 account beneficiary to yourself and then take federal-income-tax-free withdrawals to cover your own AQEE if you decide to go back to school. However, if you take a withdrawal that you use for purposes other than education, you report the taxable portion of any related account earnings as miscellaneous income on your Form 1040. Taxable amounts may also get hit with a 10 percent penalty tax. Finally, if you liquidate a 529 account that is worth less than the total amount of contributions, there are no federal income tax consequences. The government stopped participating in your losses for tax years 2018-2025.

6. Withdrawals Not Used for Education Can Also Be Hit with a 10 Percent Penalty Tax 

As explained earlier, some or all the earnings included in a 529 withdrawal taken during the year must be included in gross income when the withdrawn earnings exceed the account beneficiary’s AQEE for the year.  Per the general rule, the taxable amount of earnings is also hit with a 10 percent penalty tax. But the 10 percent penalty tax does not apply to earnings that are taxable only because the account beneficiary’s AQEE was reduced by: 

  • tax-free Pell grants;
  • tax-free scholarships, fellowships, and tuition discounts;
  • tax-free veterans’ educational assistance;
  • tax-free employer-provided educational assistance;
  • any other tax-free educational assistance; or
  • costs used to claim the American Opportunity or Lifetime Learning tax credit.

Further, the 10 percent penalty tax does not apply to earnings withdrawn when the account beneficiary attends one of the U.S. military academies, such as West Point, Annapolis, or the Air Force Academy. Finally, the 10 percent penalty tax does not apply to earnings withdrawn after the account beneficiary dies or becomes disabled.

Further reading:
IRC section 529.

Do you know that you could reduce your tax liability by proper tax planning strategy as individual or business owner?

We offer FREE initial consultation!!!

Translate »