Are you among the many who have invested in a tax-favored Section 529 college savings plan for the benefit of a child or grandchild? If you did, it may finally be time to withdraw some money to pay for the account beneficiary’s college expenses.
Qualified withdrawals, as defined by our beloved Internal Revenue Code, are always federal-income-tax-free. And usually state-income-tax-free too.
However, not all withdrawals are qualified withdrawals. So, there can be unexpected tax consequences.
Here in FAQ format are the most important things to know about 529 account withdrawals, including the federal income tax angles.
What are my withdrawal options?
Good question. You can have the withdrawal check issued in the name of the account beneficiary (the student for whom the account was set up), or the check can be issued in the name of the college.
Alternatively, you can have the check issued in your name as the account owner or plan participant. Both terms are used to describe the person who established and funded the account. That would be you, unless the account was funded with money from your child or grandchild’s custodial account. More on that later.
If the money from the withdrawal will go to the account beneficiary, I recommend having the check made out to him or her. Then have the beneficiary sign the check over to you so you can control how it’s spent.
If you’re keeping the withdrawal for yourself, if you’re allowed to do so (more on that later), have the check made out to you.
Following this advice will make it easier for the tax consequences explained below to “follow the money.”
Does it matter where the money that funded the account came from?
You betcha. You’re not allowed to keep a withdrawal from a 529 account that was funded with money from a custodial account set up for the 529 account beneficiary (usually your child or grandchild). In that situation, any money taken from the 529 account belongs to the kid and can only be withdrawn for a purpose that benefits the kid — such as buying the kid a car.
On the other hand, if you funded the 529 account with your own money, the money in the account actually belongs to you, and you can take a withdrawal for any reason you want. That said, beware of the tax implications explained later.
What does the IRS know?
Another good question. For any year in which a 529 account withdrawal is taken, the plan must issue a Form 1099-Q (Payments From Qualified Education Programs) by February 1 of the following year. If the withdrawal check is made out to the 529 account beneficiary or the college for the benefit of the beneficiary, the 1099-Q comes to the beneficiary. If the check is made out to you as the account owner, the 1099-Q comes to you. Either way, the IRS gets a copy. So, the Feds know that a withdrawal was taken and that there may be tax consequences.
“ When withdrawals exceed adjusted qualified education expenses, all or part of the withdrawn earnings will be taxable. This little-known truth can be an unpleasant surprise. ”
Box 1 of the 1099-Q shows the total amount withdrawn from the 529 account during the year. Assuming the account has made money over the years, any withdrawal will include a proportionate amount of earnings and a proportionate amount of tax basis from contributions. Withdrawn earnings are shown in Box 2 of the 1099-Q. As explained immediately below, withdrawn earnings may or may not be federal-income-tax-free. Withdrawn basis amounts are shown in Box 3, and these amounts are always federal-income-tax-free.
If heavy college costs are incurred, withdrawals taken that year are always federal-income-tax-free. Right?
Uh, no. Some or all of withdrawn account earnings might be taxable, so the IRS will be interested to see what is shown on the recipient’s Form 1040.
Withdrawn earnings are always federal-income-tax-free when total withdrawals for the year don’t exceed the account beneficiary’s adjusted qualified education expenses.
Adjusted education expenses equal tuition and related fees, plus room and board (but only if the student carries at least half of a full-time load), plus books and supplies, plus any school-related special needs services; minus costs covered by Pell grants; tax-free scholarships, fellowships, tuition discounts, and veteran’s education assistance; minus any costs covered by a tax-free employer educational assistance program; minus any costs used to claim the American Opportunity or Lifetime Learning tax credit; and minus any costs used to claim the deduction for tuition and fees (that write-off was repealed for 2021 and beyond).
For full details, see IRS Publication 970 (Tax Benefits for Education) at www.irs.gov.
When withdrawals exceed adjusted qualified education expenses, all or part of the withdrawn earnings will be taxable. This little-known truth can be an unpleasant surprise.
Example: Your daughter has $55,000 of college expenses. She receives $30,000 in tax-free scholarships and tuition discounts, so her adjusted education expenses are “only” $25,000. You take a $55,000 withdrawal from her 529 account, which includes $10,000 of account earnings.
You use the money to cover the $25,000 of adjusted education expenses plus transportation expenses, pizza, incidentals, and a car to reward your daughter for all the free money she got. Because the $25,000 of adjusted education expenses is only 45.45% of the 529 account withdrawal, only that percentage of the withdrawn earnings, or $4,545, is federal-income-tax-free. The remaining $5,455 of withdrawn earnings is taxable and should be reported on Line 8 of Form 1040, Schedule 1 (Additional Income and Adjustments to Income).
Depending on your daughter’s overall tax situation, the tax hit on the $5,455 may little or nothing. Or it may be a meaningful amount.
Advice: In this scenario, have the withdrawal check made out in your child’s name. Then have it signed over to you so you can control the spending. Better yet, have the check issued directly to the college for the benefit of your child. That way, your child will get the 1099-Q, which will keep things straight with the IRS, because your child will bear the tax consequences.
Can I take tax-free withdrawals to cover my own education expenses?
Yes, if the 529 account was funded with your own money. In that case, simply designate yourself as the new account beneficiary and take federal-income-tax-free withdrawals to cover your own qualified education expenses if you decide to go back to school.
Warning: Earnings included in withdrawals used for other purposes are taxable. Report them on line 8 of Form 1040, Schedule 1. Be aware that you will probably be hit with a 10% penalty tax on top of the income tax hit, because you did not use the withdrawn earnings for their intended purpose. See IRS Form 5329 for penalty tax details.
The bottom line
As you can see, the federal income tax treatment of 529 account withdrawals is not necessarily simple. Hopefully this column answers your questions.