New to 529 Distribution and .. yeah .. your advice needed!

Without a controlling statute or IRS regulation, my guess is that this is simply an irritating feature of the tax software.

Edited to delete a double posting (another irritating software feature – I swear that it wasn’t my fault!).

There are multiple statements above about how taxable 529 withdrawals directed to the student would be taxed at their lower rate. But this is unearned income, so won’t the kiddie tax come into play if you are providing more than 50% of their support and the amount attributable to 529 earnings (as opposed to contributions) exceeds $2100? As I understood it taxable scholarships (i.e. the part if a full ride that covers room and board) are subject to the kiddie tax and this seems similar. So will that reduce the tax benefit from directing 529 money to the student?

^^^
Yes, 529 taxable earnings that are reported on the tax return of the student/beneficiary would be unearned income and could therefore be subject to the kiddie tax and might be taxed at a rate higher than what would normally be the student’s/beneficiary’s marginal rate.

@BelknapPoint --Following up on above with two questions. Do you know if 529 distributions to students in 2018 will be handled the same way as other unearned income? Subject to estate tax rates instead of parents’ marginal rate.

Next question: similar to the question above about avoiding the 10% penalty on 529 distribution that corresponds with a scholarship. If the 529 distribution is taken only to be able to claim the AOTC, I assume that this distribution is taxed at the parents’ rate, since the parents are the ones claiming the AOTC.

I realize that I should never use the word assume when discussing taxes! Thanks.

Starting with tax year 2018, any unearned income that is subject to the kiddie tax will be taxed under the rates used for trusts and estates.

A distribution that is taken to be able to claim the AOTC would be taxed based on to whom the distribution was made payable. If the distribution was paid to the student/beneficiary (or the school), it would be unearned income taxable to the student/beneficiary, even if the parents claimed the AOTC on their tax return.

Resurrecting an old thread as I am trying to plan for year end. I welcome any comments, objections, corrections to anything I have written, as I still do not know if I understand this.

Fully-funded 529, but I qualify for the AOTC based on MAGI. I need to pay $4000 in tuition expenses using non-tax-advantaged funds in order to claim AOTC. If I disburse the $4000 from the 529, the disbursement will be taxable on the earnings portion of the distribution.

Based on what I read on the thread linked here:

http://talk.qa.collegeconfidential.com/discussion/comment/21420133#Comment_21420133

It appears that I do not need to take the distribution this year but can instead defer to next year or any time in the future. How will I report that to the IRS when the time arrives?

Alternatively, I can take the distribution this year and have it payable to myself or to my son. If payable to my son, he will be taxed on the earnings portion at the the rates outlined here:
https://www.capstonewealthpartners.com/the-kiddie-tax-changes-to-the-tax-code-in-2018/

"So, the first $2,100 of unearned income is not taxed. Amounts over the $2,100 threshold are taxed at the following rates:

Up to $2,500 – 10%
$2,551 to $9,150 – 24%
$9,151 to $12,500 – 35%
All over $12,501 – 37%
Children are no longer impacted by their parent’s tax rate plus parents don’t have to worry about adding the earnings of several siblings together."

Since the earnings on the $4000 distribution are less than $2100, he will not owe any taxes at all. He does not have any other unearned income and his summer earnings fall well below the standard deduction.

Is it ‘legitimate’ to have the funds disbursed to my son if I am the one who paid the $4000 tuition? It just doesn’t seem as though this is what the IRS intended.

Next question: how do I report any of this to the IRS, including the fact that I should not have to pay the 10% penalty since the funds were disbursed in order to claim the AOTC?

Thanks in advance to anyone who has read this far.

“So, the first $2,100 of unearned income is not taxed.”

This is something that is not entirely clear (at least to me) despite the citation above. A dependent child’s standard deduction “cannot exceed the greater of $1,050 or the sum of $350 and the individual’s earned income”. So in fact anything over $350 (assuming earned income >$700) might also incur tax at the standard (lowest) rate of 10%, before the kiddie tax comes into play.

@Twoin18 – Thanks. None of it is clear to me, to be honest! Would love to figure this out before December.

The kiddie tax doesn’t apply to earned income. Any earned income would be taxed at the taxpayer’s rate.

“The kiddie tax doesn’t apply to earned income. Any earned income would be taxed at the taxpayer’s rate.”

Yes, but the kid’s standard deduction will increase up to $12K to cover all the earned income. It won’t cover the unearned income beyond $350. So that unearned income would appear to be taxable under regular taxes (not kiddie tax) on the student’s return at the standard rate of 10% even before the kiddie tax comes into play. Fortunately taxable scholarships count as earned income for the purpose of figuring the standard deduction. But that doesn’t appear to apply to 529 distributions.

I am still confused. @Twoin18 – are you saying that 529 distributions are not considered unearned income? I cannot find anything that identifies the money as earned or unearned, but found this IRS notice that was updated Jan 31, 2018. I understand that a Jan 2018 update does not mean that it is final, especially since the instructions link to a 2017 tax form.

"Topic Number 553 - Tax on a Child’s Investment and Other Unearned Income (Kiddie Tax)
The following two rules may affect the tax and reporting of the unearned income of certain children:

If the child’s interest, dividends, and other unearned income total more than $2,100, part of that income may be subject to tax at the parent’s tax rate instead of the child’s tax rate. See the Form 8615 Instructions, Tax for Certain Children Who Have Unearned Income"

https://www.irs.gov/taxtopics/tc553

I have not found references to $350 or $1050 for 2018.

I believe the 529 distributions would be unearned income (I was pointing out that taxable scholarships are treated differently solely when calculating the standard deduction even though they are actually unearned income).

The reference to $1050 or earned income plus $350 is how the standard deduction for a dependent is calculated, which hasn’t changed (see https://www.forbes.com/sites/kellyphillipserb/2018/03/07/new-irs-announces-2018-tax-rates-standard-deductions-exemption-amounts-and-more/#36bb35e63133). So that’s what is used to calculate tax payable when you are below the $2100 threshold for the kiddie tax (note the kiddie tax is now levied at trust rates not the parent’s rate and the paragraph you quoted above is for 2017).

I think that if the student has say $1000 of earned income and $1000 of unearned income from the 529 distribution, they would pay 10% income tax on $650 (i.e. $2000-$1350) even before the kiddie tax threshold is reached.

I don’t understand, if you want to claim the AOTC, can’t you simply pay $4,000 towards tuition out of pocket, and then pay the rest of expenses with 529 funds, therefore there should not be any of the 529 distribution taxable or subject to penalty?

Also a consideration: If your 529 contributions are tax advantaged at the state level (in mine, we can deduct the amount of the contribution), there will be tax ramifications on the state return as well.

@Twoin18 — OK, now I am even more confused!

From the Forbes link you posted:

“For 2018, the standard deduction amount for an individual who may be claimed as a dependent by another taxpayer cannot exceed the greater of $1,050 or the sum of $350 and the individual’s earned income.”

Both of my children were my tax dependents last year and neither one owed taxes on payroll earnings other than FICA., because neither earned over the $6300 or $6500 threshold. Does the $1050 threshold only come into play when unearned income is involved? If so, I may be better off having the 529 fund disbursed to my name since this son earned several thousand in W-2 earnings from a summer job and I assumed that he would only owe FICA on his employment earnings.

Switching back to the 529, is the info I linked last night incorrect? This says that the first $2100 of unearned income is not taxed.
https://www.capstonewealthpartners.com/the-kiddie-tax-changes-to-the-tax-code-in-2018/

@mommdc – The 529 is fully funded, probably even a little over funded, due to tremendous stock market gains of past couple of years. I finally moved out of the more aggressive funds into a money market, so the balance is now known. I am trying to figure out the tax implications of paying $4000 OOP and then disbursing the 529 funds as opposed to just leaving them in the account.

@ordinarylives – Thanks. Money was not invested in a CT fund. I do not recall the reasoning now, but that is one less problem to worry about.

Just curious though…if the money had been in the CHET fund and the deduction against state income was claimed, would the full amount of the distribution need to be added back to state income at the time of the disbursement?

Depends on your state, but yes, I had to go back and pay state income tax on the contribution.

Yes the lower standard deduction is for unearned income. They would have a standard deduction of up to $12000 this year for earned income. But only an additional $350 for unearned income (subject to the minimum of $1050 for earned plus unearned combined). The 10% rate on this unearned income is probably still much lower than your marginal tax rate and doesn’t affect the (lack of) tax on their earned income, so distributing the money to you would likely incur more tax.

Examples: they earn $5000 plus $500 of unearned income from 529, standard deduction is $5350, they pay 10% tax on $150. They earn $1000 plus $1000 of unearned income from 529, standard deduction is $1350, they pay 10% tax on $650. They earn $500 plus $500 of unearned income from 529, standard deduction is $1050, they pay no tax.

The other article says the first $2100 of unearned income is not subject to kiddie tax. That is right but it is incorrect to suggest this (up to) $2100 is completely tax free, it is still subject to regular tax if it exceeds the standard deduction.

The linked article is a bit confusing because it seems to contradict itself.

In 2017, a child was allowed $1,050 in untaxed unearned income. No taxes on the first $1,050. Got it so far? Easy start, but after that it gets more complicated. The second $1,050 was taxed at the child’s tax rate—probably a low rate and often 0%.

And then shortly thereafter, describing the changes for 2018:

The rules on the first $2,100 of unearned income remain unchanged… So, the first $2,100 of unearned income is not taxed.

Assuming that you’re dealing with a dependent child’s unearned income that is not a taxable scholarship or fellowship grant, the first $1,050 is covered by the standard deduction and is therefore not taxable. The next $1,050 is taxed at the child’s normal rate. Anything over $2,100 is taxed under the kiddie tax formula, which for tax year 2018 is based on the rates for trusts and estates.