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Tax Man: Do You Have To Pay Tax On Withdrawals From 529 School Financial savings Plans? This can keep away from an disagreeable shock

Are you one of the many who have invested in a Section 529 college savings plan for the benefit of a child or grandchild? When you've done this, it may finally be time to withdraw some cash to pay for the account user's college expenses.

Qualified withdrawals as defined by our popular Internal Revenue Code are always income tax-free. And usually also state income tax-free.

However, not all withdrawals are qualified withdrawals. This can lead to unexpected tax consequences.

Here in the FAQ format is the key information on 529 account withdrawals, including federal income tax issues.

What are my withdrawal options?

Good question. You can choose to have the payout check drawn up on behalf of the beneficiary (the student the account was created for), or the check can be drawn up on behalf of the college.

Alternatively, you can have the check drawn up on your behalf as the account holder or plan participant. Both terms are used to describe the person who set up and funded the account. That would be you, unless the account was funded with funds from your child or grandson's custody account. More on that later.

If the cash from the withdrawal goes to the beneficiary of the account, I recommend having the check written to them. Then have the beneficiary sign the check on you so you can control how it is spent.

If you keep the payout to yourself when you are eligible (more on that later), get the check written.

Following this advice will make it easier to follow the money with the tax consequences explained below.

Does it matter where the money came from that was used to fund the account?

You can bet on it. You are not permitted to withdraw from a 529 account that has been funded with funds from a custody account set up for the beneficiary of the 529 account (usually your child or grandchild). In this situation, any money withdrawn from the 529 account belongs to the child and can only be withdrawn for a purpose that benefits the child – for example, to buy a car for the child.

On the other hand, if you have funded the 529 account with your own money, the funds in the account are actually yours and you can withdraw for any reason. However, be aware of the tax implications explained later.

What does the IRS know?

Another good question. For each year a 529 account is withdrawn, the plan must issue a Form 1099-Q (Payments from Qualifying Education Programs) by February 1 of the following year. If the withdrawal check is made out in favor of the beneficiary of the 529 account or the college, the 1099-Q goes to the beneficiary. When the check is made out to you, the account holder, the 1099-Q will come to you. In any case, the IRS will receive a copy. So the Feds know that a payout has been made and that there may be tax ramifications.

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If the withdrawals exceed the Adjusted Skilled Education expenses, all or part of the withdrawn income will be taxable. This little-known truth can come as an unpleasant surprise.

Field 1 of the 1099-Q shows the total amount debited from the 529 account during the year. Assuming the account has made money over the years, each payout includes a pro-rated amount of earnings and a pro-rated amount of tax from contributions. The withdrawn revenues are listed in Box 2 of the 1099-Q. As explained below, deducted income may or may not be income tax exempt. Base amounts withdrawn are listed in Box 3 and these amounts are always income tax exempt.

With high college expenses, withdrawals are always income tax-free this year. Law?

Oh no. Some or all of the income from the withdrawn account may be taxable. Hence, the IRS is keen to see what is on the recipient's Form 1040.

Withdrawn income is always income tax exempt if the total withdrawals for the year do not exceed the account user's adjusted qualified education costs.

The adjusted education costs correspond to the tuition fees and the associated fees plus room and board (but only if the student bears at least half of a full-time burden) plus books and accessories as well as school-related services for special needs. minus the costs covered by Pell grants; tax-free scholarships, grants, tuition discounts, and veteran education assistance; minus any costs that are covered by an employer's tax-free educational assistance program; minus any charges used to obtain the American Opportunity or Lifetime Learning tax credit; and minus any charges used to claim the deduction for tuition and fees (this depreciation has been reversed for 2021 and beyond).

For full details, see IRS Publication 970 (Tax Benefits For Education) at www.irs.gov.

If the withdrawals exceed the Adjusted Skilled Education expenses, all or part of the withdrawn income will be taxable. This little-known truth can come as an unpleasant surprise.

Example: Her daughter has $ 55,000 in college expenses. She receives $ 30,000 in tax-free scholarships and tuition discounts, so her adjusted educational costs are "only" $ 25,000. They are making a withdrawal of $ 55,000 from their 529 account that contains $ 10,000 in account earnings.

You use the money to cover the adjusted $ 25,000 education expenses plus transportation, pizza, utilities, and a car to reward your daughter for all of the free money she received. Since the $ 25,000 adjusted education cost is only 45.45% of the 529 withdrawals, only that percentage of the deducted income, or $ 4,545 is federal income tax exempt. The remaining $ 5,455 of deducted income is taxable and should be reported on line 8 of Form 1040, Appendix 1 (Additional Income and Income Adjustments).

Depending on your daughter's general tax situation, the tax hit may be small or nonexistent at $ 5,455. Or it can be a reasonable amount.

Advice: In this scenario, have the withdrawal check drawn up on your child's behalf. Then get your signature so that you can control the expenses. Better yet, have the check written directly to the college for your child's benefit. This way, your child will get the 1099-Q which will bring things into line with the IRS as your child will face the tax ramifications.

Can I make tax-free withdrawals to cover my own education costs?

Yes, if the 529 account was funded with your own money. In that case, simply designate yourself as the beneficiary of the new account and make income tax-free withdrawals to cover your own skilled education costs when you decide to go back to school.

Warning: Income from withdrawals used for other purposes is taxable. Report it on line 8 of Form 1040, Appendix 1. Note that you will likely be subject to a 10% penalty tax on top of your income tax deduction for not using the deducted income for its intended purpose. For more information on penalty tax, see IRS Form 5329.

The final result

As you can see, federal income tax handling 529 account withdrawals is not exactly straightforward. Hopefully this column answers your questions.

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