529 "unqualified distributions" and tax penalties

Does anyone have experience with unqualified 529 distributions? I understand that (1) only the earnings portion of an unqualified distribution is subject to tax, and (2) that generally a 10% penalty is added to the tax amount, and (3) that the earnings portion of unqualified distributions is considered income of the beneficiary (not the parent). If all that is true, and if the beneficiary has a total income (including the distribution earnings) low enough not to pay taxes anyway (say, lower than 12K/year as an individual), then would there in fact be zero taxes and zero penalty as a result of the unqualified distribution?

@BelknapPoint ?

Correct.

Yes; although there are exceptions.

No; if the unqualified distribution is made to the account owner (who in most cases is probably a parent), that person will need to report the earnings as taxable income on his/her tax return and possibly pay the 10% additional tax as well.

No; any 10% additional tax that applies will eventually end up on Form 1040 line 14 (“Other taxes”), which enters the tax mix after any deduction is applied. So, a taxpayer with 529 unqualified earnings to report could end up with an AGI of $0 after deductions, no taxable income, and therefore no tax on line 13, but the 10% additional tax would still show up on line 14 and would have to be paid.

For federal. If you were allowed a state tax deduction for your contributions, the whole amount may be subject to state tax.

As noted, the money is taxable to the account owner. Otherwise, everyone would be opening accounts and maximizing the funding every year and then having their young child “withdraw” the money.

Earnings from a non-qualified distribution are taxable income for either the beneficiary or the account owner, depending on to whom the distribution was made payable. If the distribution was made payable to the beneficiary or the school, the earnings are taxable income to the beneficiary. If the distribution was made payable to the account owner, the earnings are taxable income to the account owner.

Thanks all for helping me understand how this works. As BelknapPoint suggests, I assume now that the “10% extra” penalty must be paid regardless of the lowness of income, and would be considered “other taxes”. The interesting thing to me is that the total “hit” of the penalty would be much lower for someone with lower income, because the main part of the penalty (the regular income taxes on the earnings) would be zero as long as an individual filer’s income is less than about 12K, from what I understand.
We live in a state with no income tax, so state tax is not a consideration.
This issue is important to us because my kid is considering studying in a college abroad that has no relation with FAFSA, thus no way to use 529 in the standard “qualified” way. If our penalty for using it in an “unqualified” way is not high, then it may make sense to do so.
I suppose the “wild card” variable is if the host country would assess any tax on it!

I assume that means that the college is not eligible for Title IV higher federal education aid. Just want to make sure that is actually the case as many overseas colleges do qualify.

The foreign college we are mostly interested in has a “deferment only” relationship with US Dept of Ed. According to some accounting sites, it is doubtful that such colleges would be approved by IRS for qualified 529 distros, since they are not approved to actually receive US fed loan money (US students can only defer loans they already incurred while attending such colleges). However, there is apparently some diff of opinion among accountants. Would probably just have to try it out and see what the IRS would do, but be prepared to pay the comparatively small penalty. Another problem is that the list of foreign colleges that “participate” with US Ed changes from year to year. If the college you’re going to is on the list this year, then it might not be the next year. In general, I think fewer colleges are on the list now than approx 14 years ago when I first looked at it. Apparently, the colleges determine individually whether it is worth their while to keep up with US Ed paperwork. Many of the best foreign Univs aren’t on the US Ed list at all.

Although if the distribution is made to your child who is attending college and does not provide more than half of their own support, then kiddie taxes may be assessed. In that case the $12K standard deduction would also no longer be applicable since the 529 distribution is not earned income.

This is an important point which should be kept in mind. If OP’s child can be claimed as a dependent on someone else’s tax return, the child’s standard deduction may be as low as $1,050.

The IRS discusses “What is an Eligible Educational Institution?” here: https://www.irs.gov/credits-deductions/individuals/earned-income-tax-credit/eligible-educational-inst

They make reference to the Dept. of Ed.'s Federal Code School List, which is linked here: https://ifap.ed.gov/ifap/fedSchoolCodeList.jsp

You can download an Excel spreadsheet from that site.

If you sort that list by State, and scroll down to “FC” you can see all the 328 foreign colleges and universities that currently qualify.

Back to the IRS page, they do mention: “TIP: A small number of schools, not on this list, may be eligible educational institutions. So, you may need to ask the school.”

Hi Colfac. Thanks for sending the links. There is another similar list of schools on a US Ed website, but there are some notable differences, so I’m wondering if the “right arm isn’t talking with the left” in terms of eligibility.

For example, Tohoku University is the ONLY univ in Japan that appears on the list of the link you sent (referred to specifically by the IRS) https://ifap.ed.gov/ifap/fedSchoolCodeList.jsp

However, on the US Ed web page https://studentaid.ed.gov/sa/types/international#participating-schools there is a link about halfway down the page for an excel sheet titled “International schools that participate…" On this excel sheet, there are four univs in Japan listed (including Tohoku U) but they are all listed as “deferment only.” From my online search, accountants’ opinions vary on whether such schools would actually be eligible for 529 distributions without penalty.

Coincidentally, Tohoku U is probably the main foreign school my son is interested, so the list you sent might bode well for him.

Hi Twoin18. Good point about the kiddie tax! My understanding: (1) if the 529 distro is UNqualified and paid to the student, then kiddie tax would apply (for the student) only to the earnings portion, NOT the principle, and (2) if the distro is qualified, then there is no issue of kiddie tax even if paid directly to the student.
If both those are true, then what would happen if the distro is UNqualified but paid directly to the institution? Is that possible? Would I pay the tax and penalty on earnings in that case?

Any 529 distribution paid directly to the school is treated the same as if it was paid to the beneficiary.

I finally found someone who has direct experience with a child attending a “deferment only” foreign U. She says, from what she’s learned, that such schools will NOT invoke the 529 unqualified penalty. For anyone with similar questions, here is her informative post: https://forum.savingforcollege.com/t/international-universities-go-on-off-the-federal-student-code-list-and-529s/11786

For the sake of complete understanding and clarification, it’s not the school that invokes the tax penalty on the earnings portion of an unqualified 529 distribution; it’s the IRS based on federal tax law.