529s generate taxable income?

Parents Forum
1

<p>We had an opportunity to lock in my son's first year tuition/room/board for four full years by paying ahead of time.</p>

<p>We did this by cashing in all his 529s. It covered all four years to the dime. Son is currently a sophomore.</p>

<p>Now the IRS has notified us that the interest received on the 529s is counted as income. Huh??? Does this have to do with prepayment (i.e. perhaps the interest is tax-free <em>only</em> during the current year), or is this a coding error by the IRS (or the 529 company)?</p>

<p>Thanks for any light you can shed.</p>

2

<p>There are very clear rules as to how much is tax exempt:</p>

<p>Here is the official IRS publication on this issue</p>

<p>[Publication</a> 970 (2010), Tax Benefits for Education](<a href=“Publication 970 (2022), Tax Benefits for Education | Internal Revenue Service”>Publication 970 (2022), Tax Benefits for Education | Internal Revenue Service)</p>

<p>*
The part of a distribution representing the amount paid or contributed to a QTP does not have to be included in income. This is a return of the investment in the plan.</p>

<p>The designated beneficiary generally does not have to include in income any earnings distributed from a QTP if the total distribution is less than or equal to adjusted qualified education expenses (defined under Figuring the Taxable Portion of a Distribution , below). *</p>

<p>In other words, the distribution is less than the qualified education expenses, you are OK. This publication gives an example</p>

<p>

[quote]

Earnings and return of investment. You will receive a Form 1099-Q, Payments From Qualified Education Programs (Under Sections 529 and 530), from each of the programs from which you received a QTP distribution in 2010. The amount of your gross distribution (box 1) shown on each form will be divided between your earnings (box 2) and your basis, or return of investment (box 3). Form 1099-Q should be sent to you by January 31, 2011.</p>

<p>Figuring the Taxable Portion of a Distribution</p>

<p>To determine if total distributions for the year are more or less than the amount of qualified education expenses, you must compare the total of all QTP distributions for the tax year to the adjusted qualified education expenses.
Adjusted qualified education expenses. This amount is the total qualified education expenses reduced by any tax-free educational assistance. Tax-free educational assistance includes:</p>

<pre><code>*

The tax-free part of scholarships and fellowships (see chapter 1),
*

Veterans’ educational assistance (see chapter 1),
*

Pell grants (see chapter 1),
*

Employer-provided educational assistance (see chapter 11), and
*

Any other nontaxable (tax-free) payments (other than gifts or inheritances) received as educational assistance.
</code></pre>

<p>Taxable earnings. Use the following steps to figure the taxable part.</p>

<p>1.</p>

<pre><code> Multiply the total distributed earnings shown in box 2 of Form 1099-Q by a fraction. The numerator is the adjusted qualified education expenses paid during the year and the denominator is the total amount distributed during the year.
</code></pre>

<p>2.</p>

<pre><code> Subtract the amount figured in (1) from the total distributed earnings. The result is the amount the beneficiary must include in income. Report it on Form 1040 or Form 1040NR, line 21.
</code></pre>

<p>Example 1.</p>

<p>In 2004, Sara Clarke’s parents opened a savings account for her with a QTP maintained by their state government. Over the years they contributed $18,000 to the account. The total balance in the account was $27,000 on the date the distribution was made. In the summer of 2010, Sara enrolled in college and had $8,300 of qualified education expenses for the rest of the year. She paid her college expenses from the following sources.
Gift from parents $1,600<br>
Partial tuition scholarship (tax-free) 3,100<br>
QTP distribution 5,300 </p>

<p>Before Sara can determine the taxable part of her QTP distribution, she must reduce her total qualified education expenses by any tax-free educational assistance.
Total qualified education expenses $8,300<br>
Minus: Tax-free educational assistance −3,100<br>
Equals: Adjusted qualified<br>
education expenses (AQEE) $5,200 </p>

<p>Since the remaining expenses ($5,200) are less than the QTP distribution, part of the earnings will be taxable.</p>

<p>Sara’s Form 1099-Q shows that $950 of the QTP distribution is earnings. Sara figures the taxable part of the distributed earnings as follows.
1. $950 (earnings) </p>

3

<p>I am no expert but when we cashed out our 529 (which sadly covered only part of DS’s first year :(), our accountant ‘matched’ that with statement from DS’s U regarding amount paid to them for allowable expenses on our tax return. Kinda like the form from your mortgage company. Did you not get one from the U when you paid them the money?</p>

<p>The income should not be taxable but you do have to provide proof that it was not spent on a car. My guess is you’d have to get a letter from the U that you paid it and amend your tax return for that year. I trust those more knowledgeable will weigh in.</p>

<p>x-posted with maze</p>

4

<p>I think the issue here is that you have paid for 4 years but what the IRS is taking into consideration is the expenses for this year. So if you paid $100,000 from the 529 (for 4 years), and the qualified expenses is $25000 (for this year), you need to pay tax on the remaining amount based on their calculation i.e. ($100,000-$25000), even though you will use it up in other years.</p>

<p>I do not know if you can recapture the losses in subsequent years. Talk to a tax accountant, they may have some ideas as to how to minimize the tax burden. I suppose this is the catch for prepaying tuition from 529 funds.</p>

<p>Alternatively they are assuming that you have taken withdrawal, as the amount withdrawn does not match the qualified expenses.</p>

5

<p>Timely thread. I came home Friday to a letter from IRS telling me I owed tax on the income portion of our 529 withdrawals in 2009 (2 kids in school), plus interest of course. What’s curious is that they indicated the entire income portion of each withdrawal was taxable for each child. As if we didn’t make any college payments at all (if only, ha!).</p>

<p>I made copies of the 1098-Ts from the colleges to match them up against the 1099-Qs from the 529s. Clearly demonstrating that our payments in 2009 exceeded our 529 withdraws. I sent this info to IRS. Hopefully, this will be sufficient. We’ll see….</p>

6

<p>To the OP: did you have the 529 disbursement paid directly to the school for the 4 years or did you pay it yourself and cashed out the 529 to you?</p>

<p>The answer will determine the next steps you need to take:</p>

<p>1) if you paid the school directly through the 529, this should not have happened but nevertheless the school can help you by providing a statement that you have prepaid 4 years up front…</p>

<p>2) if you paid the school through your own personal funds and then reimbursed your $$ by cashing out the 529’s, you need to ask your accountant how to rectify…</p>

<p>When my daughter entered college in 2008, we asked the FA office if we could cash out the 529’s to prepay for 4 years of tuition; they told us that this flags the IRS and was not recommended…they also would not allow us to do it since she had a merit scholarshp (they don’t allow prepayment of tuition with any sort of aid issue)</p>

7

<p>I could be wrong, but my impression is that the OP’s son is a sophomore in high school, not college. Otherwise, they would have already paid for two years of college tuition, but the OP mentioned using the 529 funds to pay for four years. If he is a high school student, there aren’t any qualified education expenses yet.</p>

8

<p>Correct me if I am wrong, but does the post imply that the OP cashed out all 529s to lock in tuition for 4 years by prepaying to the college? If that is so, my understanding is that the 529 can only be cashed out, annually, to cover and not exceed all cost incurred for the year. Perhaps, the IRS saw that the amount cashed out, exceeded the actual incurred cost for the year and assumed that the rest are non-qualified withdrawal and therefore tax is due. We may be in the same boat next year, so any clarification will be appreciated.</p>

9

<p>OP here, thanks for all your comments.</p>

<p>Son is sophomore in college. Just before he started as a freshman (in August 2009), we received the bill. School has a plan where you can pay four years and lock in tuition/room/board, or just pay for that one year and subsequently pay all the hikes in tuition/room/board.</p>

<p>We had enough money saved in his 529 to pay for all four years. If we just paid for one year, given the markets, we didn’t think we’d be able to cover subsequent years. So we paid all four years.</p>

<p>Holding company sent money to school directly. We never saw a dime.</p>

10

<p>Did you get a 1098T from the university for 2009? What did it say?</p>

11

<p>heyalb: then, if the 529 paid directly to the school, the school has that record and needs to generate a 1098T statement to that effect…</p>

<p>If they cannot do that, they should never have accepted the enormous 529 payment in the first place…directly from the holding company</p>

<p>I am not an accountant, but maybe yours could be of assistance…</p>

<p>I wonder if there is some obscure IRS-529 regulation that mentions this issue of prepaid tuition vs tuition billed/year…no idea</p>

12

<p>Please keep us posted on the outcome! My S starts college this fall, and his school has a similar program to prepay and lock in tuition. I was thinking I couldn’t use his 529 that way, since withdrawals need to match yearly expenses, but if you are successful, I would love to hear. Good luck.</p>

13

<p>OP here again.</p>

<p>The school generates the 1098-T on an annual basis, for that year’s qualified tuition only. Apparently, that’s the way it’s done. I recently received 2010’s, and then on its heels came the lovely letter from the IRS.</p>

<p>Great, the school gets their money, the IRS is getting their cut, and I’m the one who saved for a lifetime, and I get hit with back taxes and penalties. No good deed goes unpunished. I’m working with my accountant, but I think I can expect one of two things: (1) back taxes and penalties, or (2) a protracted arguement with the IRS, which may, indeed, end with even higher penalties.</p>

<p>Neither one is any fun.</p>

<p>WARNING parents: if you prepay, do it out of your own funds, not your 529.</p>

14

<p>I hope OP the best and gets this straighten out to your satisfaction. But this brings another interesting case I can think of. If we pay for tuition bill for spring semester due on the 3rd of January and we took out the money from 529 before December 31st, does the money from 529 taxable because it was taken from previous year and cannot be matched up with 1098-T from the college in the next year?</p>

15

<p>It sounds like the OP got caught by the unfriendly cash-out rules of 529s which require that the money be spent in the calendar year that it was withdrawn. This goes to ttparent’s question as well - if tuition is due on 1/3, it must be withdrawn on 1/2 rather than the year before. I’ve shifted my own money around to pay tuition, then reimbursed myself from 529 funds, making sure the calendar year payments are in synch.</p>

<p>There might have been another alternative for the OP if his son’s college is a participant. There’s a program called the i529 which locks in 4 years of college at the current tuition amount. So if this year’s tuition is $10,000, then all 4 years would be at that rate - you’re protected from any increase. However, the funds must remain in the account for at least 3 years before they can be withdrawn, making it impractical for current college students. Conventional 529 funds can be rolled over into an i529, which means they aren’t subject to early withdrawal penalties and taxes.</p>

<p><a href=“https://www.privatecollege529.com/[/url]”>https://www.privatecollege529.com/&lt;/a&gt;&lt;/p&gt;

16

<p>^ All stuff I didn’t know, vballmom. If I’m looking for a silver lining here, the tax on the full withdrawal is less than what the tuition/room/board increases would have been over the four years.</p>

<p>In the grand scheme of things, not awful, but I have to come up with a wad of cash that I hadn’t planned on nor budgeted for. :(</p>

17

<p>Ugh, what a shame! If it’s more than a few hundred I’d consider consulting an accountant to see if there’s any way to rectify this. There may indeed be nothing you can do, and it would be a shame to throw good money (accountant fees) after bad, but a brief consultation may be worthwhile.</p>

18

<p>your tax liability and penalty is limited to the “gains” not the original principal investments.</p>

19

<p>I’ll add my voice to the chorus “Get a Professional opinion (or two).” As LongPrime says, if there MUST be interest and penalties, they should only apply to only a portion of the 529 withdrawal. If you decide to get serious about resolving this problem, I’m pretty sure your Professional could find a way to eliminate tax consequences.</p>

20

<p>OP here again. Yes, the taxes are applied to only the gains. We’ve saved for full private college over 18 years. The gains are substantial, and so are the taxes on those gains.</p>

<p>I have consulted with a professional. About the only thing I can do is to try and get the remaining two years of tuition/room/board back from the school, re-deposit it back in the 529, and re-file taxes. At that point, the college would, no doubt, hike the tuition/room/board for my son’s final two years there.</p>

<p>Somebody up there said “chasing good money after bad”. We slept on it last night, and we decided we’re going to take our lumps and join the ranks of Americans who think the middle class are paying more than their fair share.</p>

<p>That, and find a wad of cash somewhere in our “Swiss bank account”. </p>

<p>Thanks to everybody who posted…even though you can’t help me pay this, I’m just glad you’re there.</p>