Understanding the Taxation of 529 Plans for Non-Qualified Expenses or Closure
A 529 plan is a tax-advantaged savings plan designed to encourage saving for future education costs. Named after Section 529 of the Internal Revenue Code, these plans are sponsored by states, state agencies, or educational institutions and offer tax benefits when used for qualified education expenses.
But what happens if you have to withdraw money for reasons other than qualified education expenses? Or what happens if you no longer want or need the 529 plan and want to close it?
Using 529 funds for non-qualified expenses can result in tax consequences. This article will delve into the taxation aspects, including the 10% penalty exemptions, differentiation between basis and gains, and state considerations for those who received a tax credit or deduction.
Qualified versus Non-Qualified Expenses
Qualified Education Expenses are those expenses that are outlined by the IRS. In general, they are expenses that are necessary for the education including tuition, books, room and board, supplies, and computers. For a comprehensive list of qualified education expenses, see Publication 970 (2023), Tax Benefits for Education | Internal Revenue Service (irs.gov)
Non-Qualified Expenses are simply any withdrawals for items that are not Qualified Education Expenses.
Taxation of Non-Qualified Withdrawals
When 529 plan funds are used for non-qualified expenses, the earnings portion (gains) of the withdrawal is subject to federal income tax and a 10% additional tax penalty. It is crucial to understand the implications of this and how to manage the withdrawal process.
Basis versus Gains Taxation
When funds are withdrawn from a 529 plan, it is essential to distinguish between the basis (the amount contributed) and the earnings (the gains).
- Basis: The original contributions made to the 529 plan. Withdrawals of basis are always tax-free, as contributions were made with after-tax dollars.
- Gains: The earnings on the contributions. Withdrawals of gains for non-qualified expenses are subject to income tax and potentially a 10% penalty.
Withdrawals, whether qualified or not, are always completed on a pro-rata basis meaning they pull out both gains and basis based on the percentage each represents in the account.
To calculate the taxation of the withdrawal, you would multiply your federal income tax rate plus 10% by the amount of earnings.
Exemptions from the 10% Penalty
The 10% penalty on earnings can be waived under certain circumstances, including:
- Death or Disability of the Beneficiary: If the beneficiary dies or becomes disabled, the penalty is waived, although the earnings are still subject to federal income tax.
- Scholarship: If the beneficiary receives a scholarship, an amount equal to the scholarship can be withdrawn without incurring the 10% penalty, although the earnings portion will still be taxed.
- Military Academy Attendance: If the beneficiary attends a U.S. military academy, the penalty does not apply to the amount equal to the cost of education.
- Use of American Opportunity Tax Credit (AOTC) or Lifetime Learning Credit (LLC): If the beneficiary uses these credits, the penalty can be avoided for the corresponding amount.
State Considerations
If you received state tax credit or deduction for contributions to the 529 plan, there are additional complexities to consider. Here are key points to consider:
- Recapture of State Tax Benefits: Some states require the recapture of tax deductions or credits if withdrawals are used for non-qualified expenses. This means you may need to pay back the state tax benefits received in prior years.
- State-Specific Rules: Each state has its own rules regarding the taxation and recapture of benefits for 529 plans. It is essential to understand your state’s specific regulations.
- Impact on State Income Tax: In addition to federal income tax, non-qualified withdrawals may also be subject to state income tax on the earnings portion.
Summary
Using 529 plan funds for non-qualified expenses can have significant tax implications, including federal income tax on earnings, a potential 10% penalty, and possible state tax recapture of benefits. However, exemptions from the penalty are available under specific circumstances, such as scholarships or disability. It is crucial to differentiate between the basis and gains when calculating the taxable amount of non-qualified withdrawals. Additionally, state tax considerations must be taken into account, as state-specific rules and potential recapture of tax benefits can impact the overall cost.
Understanding these aspects allows you to make informed decisions about managing 529 plan funds, ensuring that you maximize the tax benefits while minimizing any potential penalties and taxes.