Accountants and tax professionals whose clients want to take money out of a 529 college-savings plan should forewarn them: Proceed with care. Better yet, tell them to let you calculate it.
If done incorrectly, clients can face additional taxes and penalties, according to a recent Morningstar report.
Here’s the key and why consulting with a CPA or tax professional is crucial: In any tax year — not academic year — the amount of money withdrawn from the plan can’t be more than the qualified education expenses. Tax-free educational assistance (scholarships and grants) and credits like the American Opportunity Tax Credit or Lifetime Learning Credit have to be calculated.
Withdrawals that are more than those qualified expenses are subject to taxes on the earnings part of the withdrawal and could bring a 10 percent penalty.
First of all, 529 plans cover tuition and fees; books, supplies and equipment, including computer costs and internet access as long as they are used primarily by the beneficiary of the plan while he or she is a student; and room and board for students enrolled at least half the time and the room and board costs can’t be more than the greater of the room and board allowance included in the cost of attendance set by the school and the actual amount charged if the student lives in housing owned or operated by the school.
So, in figuring the qualified education expenses (QEE), taxes aren’t paid on the contributed amount, which is funded with after-tax dollars and generally aren’t due on earnings distributed from the 529 if the total distribution is less than or equal to adjusted qualified education expenses. Otherwise, additional taxes and the penalty can be incurred.
The penalty won’t be incurred on a nonqualified withdrawal for students who receive scholarships, up to the amount of the scholarship. But he or she will still owe taxes on the earnings part of the excess distribution.
After you or your client adds in the QEE, subtract the amount of any tax-free educational assistance, such as tax-free scholarships and fellowship grants, veterans aid, the tax-free part of the Pell grant, employer educational assistance and any other tax-free aid — but not gifts or inheritances.
The total is the adjusted QEE.
Let’s say a client does this alone and incurs a distribution that is more than the QEE. He or she will get a Form 1099-Q from any 529 that issued a distribution in 2017.
Terry Sheridan is an award-winning journalist who has covered real estate, mortgage finance, health care, insurance, personal finance, and accounting and taxation issues for newspapers, magazines, and websites. A Chicago native and former South Florida resident, she now lives in New England.