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

@BelknapPoint

“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.”

$4000 in earned, summer employment W-2 income and $1600 in earnings from 529 distribution. No scholarships, grants, dividends, or any other sort of money involved. Does his $4000 in W-2 earnings impact the calculation of the kiddie tax on the $1600 of unearned income from the 529 distribution? If not, then is the tax due $1600 less $1050 = $550 @ 10% estate tax rate?

The kiddie tax only applies to unearned income, so the $4,000 in earned W-2 income will not factor in to kiddie tax calculations. And since the unearned income is less than $2,100, the kiddie tax won’t apply at all. Your dependent child will have a standard deduction of $4,350 (earned income of $4,000 plus up to $350 in unearned income, but not more than the standard single deduction of $12,000 for 2018), resulting in taxable income of $1,250. This will be taxed at the standard single rates for 2018, which is 10% for amounts up to and including $9,525, resulting in a tax owed of $125.

Edited to add: there are lots of caveats here, one of which is this: a dependent’s minimum standard deduction is $1,050, so if your child’s only income was the $1,600 in earnings from the 529 distribution, that would leave $550 in taxable income. The $4,000 in earned income changes that, because the standard deduction then becomes something greater than $1,050, and only $350 of the unearned income is covered by the standard deduction. It can be very confusing if you try to think of it all at once. Instead, take it step-by-step and it makes a lot more sense.

@BelknapPoint – To say this is confusing is a vast understatement. Thank you for working through the example.

Do you have any idea where I will report this unearned income to the IRS and that the 10% penalty is not due because the disbursement was to allow the AOTC to be claimed? It still seems odd to me that I can claim the AOTC but that my son will report the taxable income. The 529 is set up with me as owner FBO my son. Hopefully that ownership structure allows what I am planning to do.

I can only give you information based on the 2017 tax forms; the 2018 forms won’t be available until late in the year (at the earliest). There will be changes to the forms because of the big changes to the tax code for 2018.

For tax year 2017, the earnings portion of a non-qualified 529 distribution was reported as taxable income on line 21 (“Other income”) of the 1040. This triggered the requirement to complete form 5329 (“Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts”), specifically Part II (“Additional Tax on Certain Distributions From Education Accounts and ABLE Accounts”). Form 5329 must be completed, even if no additional tax is actually owed because an exception applies.

https://www.irs.gov/pub/irs-pdf/f5329.pdf

Yes, you are allowed to do what you are planning to do, which is you claiming the AOTC on your tax return, even though your son will be reporting and paying tax on the earnings portion of the 529 distribution. See example 2 on pg. 52 of IRS pub 970:

https://www.irs.gov/pub/irs-pdf/p970.pdf

In an earlier post you seemed to contemplate not reporting the non-qualified distribution that was tied to an AOTC claim until a tax year after the year in which the AOTC was claimed. I don’t think you want to do this, or even can do it. If you are declaring part or all of a 529 distribution as non-qualified in order to use those funds to qualify for the AOTC, do everything in the same tax year: take the 529 distribution, pay the qualified expenses, claim the AOTC, and report as non-qualified whatever part of the 529 distribution needs to be so reported in order to get as much benefit as possible from the AOTC.

@BelknapPoint – I cannot thank you enough.

Knowing where to look on 2017 forms is a huge help, and I agree with you that we may not have the needed forms by year end.

Thank you for double-confirming that what I plan to do is allowed. I can’t say that the examples on page 52 cleared things up for me!

I plan to use 529 funds to pay: tuition less $4000; 100% of cost of room, board, and textbooks. I will cut a personal check for $4000 to the university out of my own checking account to cover the $4000 in tuition not paid by the 529 plan. I will have $4000 disbursed to my son from the 529, and the 1099-Q clearly breaks out the earnings and basis amounts of the distribution, making it easy to report the earnings on what had been line 21 of the 1040, and then to file Form 5329, assuming it still exists next year.

The only reason I contemplated not reporting the earnings portion of the 529 distribution this year was my misreading of something you wrote several months ago. Upon closer inspection, it appears your response was only about 529 disbursements to cover scholarships, not disbursements to take advantage of AOTC. It seems cleaner to handle all of these transactions in the same calendar year.

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

THANK YOU again.

It seemed to me that your main concern here was you claiming the AOTC while your son paid tax on the non-qualified 529 distribution that the AOTC was based on. The example cited covers a similar situation where the parents claimed the AOTC and the student paid tax on the earnings portion of the non-qualified 529 distribution that was used for the tax credit.

Note that if any 529 funds that pay for tuition less $4,000, room and board, and textbooks are paid directly to the school, that will be reported on the 1099-Q that goes to your son. If there are multiple 529 distributions over the tax year, just keep track of what each one was used for and what the breakdown was between earnings and contributions for each distribution.

Exactly; an exception to paying the 10% additional tax applies in both situations, but because of the way in how the exception comes about, the timing can be very different.

You are very welcome. Good luck going forward, and remember: if you have any doubt about the right way to do all this stuff, consult with a reputable tax professional. You should never rely on tax advice received over the internet without first being sure that everything checks out.

@BelknapPoint – Fortunately the 529 Administrator makes it very easy to track as each disbursement is accompanied by a statement that shows the basis & earnings amounts for each fund. Since I have finally lost my nerve and moved the entire balance to money market, the transaction sheet will be even cleaner for the late 2018 disbursements.

If only I could find a tax professional who understood this all as well as you do!