We’re super lucky to have a student that received a near full-ride national merit scholarship. We are now trying to figure out what to do with the over-funded 529 funds and best way to minimize taxes upon withdrawal.
We are familiar with other places that we can move the 529 (future kids, grandkids, future education, etc) but this currently isn’t of interest. We are essentially trying to figure out if there are any ways to minimize taxes and best ways to be drawing down funds? I’ve seen a number of articles re: ability to withdrawal 529 funds when you have scholarships, but am looking for what your might personally be doing.
Yes, D18 got a full ride and has about $100K extra left in her 529. We gave her some cash that we would otherwise have contributed for her younger brother and transferred that amount to his 529. The new tax law will also allow us to put $35K in her Roth IRA starting in 2024.
But we are in the process of withdrawing some money to help pay her living expenses now she’s graduated (she is a ballet dancer with minimal income).
My key conclusion is that it’s a bad idea to withdraw while your kid is in college if they would be subject to kiddie tax (your tax rate on unearned income, which 529 distributions are). That will be the case unless they have a high enough paid summer job to be providing more than half of their own support (remember the scholarship isn’t counted so their total support may be quite limited and earning $5K+ in the summer may be enough).
The year they graduate it is likely they will provide more than half their support if they start a job promptly. That’s a good time to withdraw money because their effective tax rate will be low. If not then opt for the next year after when they are not in full time education for at least part of five months.
It is not fully defined whether you could avoid the 10% penalty on post college withdrawals. Tax programs like TurboTax will assume you need to pay this. On the other hand, the recent law change to allow Roth transfers suggests that Congress doesn’t necessarily intend for later withdrawals to be penalized. Basically the law and IRS are silent on this, so it’s at your own risk. I haven’t decided yet (we just made the first withdrawal this month) but her tax rate is otherwise going to be minimal.
Not relevant to your current situation, @kbeducator, but for others reading here, it might be worth noting that if your child attends a service academy (beginning with the 2003 tax year) the Military Family Tax Relief Act eliminated the 10% penalty:
President George Bush signed the Military Family Tax Relief Act of 2003 (HR 3365) on November 11. Among other items, the Act provides that attendance at a U.S. military academy will be treated as a scholarship for purposes of the 10% penalty on nonqualified withdrawals from a 529 plan or Coverdell ESA. The value of the no-cost education (as determined under the U.S. military code) can be withdrawn penalty-free from a 529 plan or CESA, although the earnings portion will continue to be taxable.
The academy advised either keeping the funds intact until graduation in case something were to separate a cadet who would then need those funds for civilian college or withdraw them at a rate equal to a civilian college payment schedule. In our case, we withdrew the funds in eight equal distributions tied to our son’s tuition-free semesters at USMA. We retired early.
I think an additional benefit is that your S would no longer have been a dependent so not subject to kiddie tax. That’s more challenging to achieve at other colleges as it generally requires a high paid summer job.
But scholarships above tuition and books are taxable and have been for a long time. (I paid in the 1990s) They are considered earned income in IRS publication 929 in the definitions section. Plus, 529 distributions have a formula that means you can take out the value of certain scholarships penalty free. It has to do with the portion that was earnings vs. deposit.
D17 started filing taxes every year at 18 because the income from the value of room and board put her at paying more than half her annual support. I mean, if someone is on a full ride, what is the support from the parents?
If I were OP, I would read ALL the publications that deal with child/dependent income (929 among others) and to do with 529 distributions and taxes/penalties. Then do the numbers by hand and see what you should do. We still do taxes by hand, so that is what we did to maximize transferring the money out of the 529 while minimizing taxes, but she did pay taxes on the earnings portion.
They really want to have people save in the 529, so they make it sort of easy to take the amount of the scholarships back out, but it is NOT simple and is filled with contradictions. Also read IRS 970 (section on QTPs) and do all the calculations- in each booklet be sure to read what counts as earned income and what does not. It literally changes from calculation to calculation!
Most important- the value of room and board and extra IS taxable whether you offset the 529 or not! (See IRS topic 421) It is easier to take the 529 money out without penalties while they are getting the scholarship as far as we could tell. BUT- as with all things taxes, every person and website and professional gives a different answer, so we just printed all the booklets to keep for proof in an audit of how we came up with our numbers and did it by hand.
** Important- I am not a tax person at all.
If your kid is aged under 23 and they are in college for more than 5 months in a year, then unless they provide more than half of their own support, their unearned income (above a low threshold) is taxed at the parents’ marginal rate (referred to colloquially as “kiddie tax”). That includes 529 money (though taxable scholarships are treated slightly differently, since for those you get to use your full personal allowance first).
As a result, instead of being taxed at 0-10% federal rates (as might be expected for a low income young person), they may be taxed at 28% or higher on the 529 earnings.
Following - we have 3 over funded 529s . Plan is to leave funded to ensure no need for graduate school but the Roth IRA option is very intriguing . . . need to read more about it. Is it only for the beneficiary or can you deposit for the owner? Income limits? I assume back door Roth contribution won’t work since you have to first deposit into contributory IRA which may trigger withdrawal penalty.
That’s incorrect, the scholarship must be deducted from total support, whether it’s taxable or not:
“ Scholarships.
A scholarship received by a child who is a student isn’t taken into account in determining whether the child provided more than half of their own support.”
What you need to add up for parental support includes any spending money provided, plus the value of imputed rent for any time they spent at home (based on a pro rata share of mortgage, insurance, food etc), plus the value of any other incidentals (of which health insurance may be the largest) and compare it to their income. That’s why I said even with a full ride they may need to earn $5000+, and more if they live at home during the summer and don’t pay rent.
It is an hybrid, it counts as earned income for calculating the deduction and unearned for the kiddie tax. So you are still subject to kiddie tax if the taxable portion exceeds the standard deduction. This was a major controversy in 2020, because of the impact on gold star families and poor families with full rides because of the 2017 change to charge kiddie tax at trust and estate rates.
Yes, I think I’m saying the same thing. Scholarship income is taxed as unearned income and can’t be used in calculating support for students (that is, it isn’t treated as earned income that can establish that a student can’t be claimed as a dependent).
Only for the beneficiary and has a 5 year waiting period after the contribution is made and 15 years after the account is set up. And still subject to the $6500 per year contribution limit so the $35K needs to be spread out over 5+ years.
The best news is that it’s exempt from the normal Roth income limits so you can use it for high earners (eg if your kid’s income increases rapidly after starting a job). I wouldn’t be surprised to see some high income adults setting up 529 accounts with themselves as a beneficiary and transferring the money after the 5/15 year waiting period
Sorry, I was not referring to not counting the child as a dependent.
I was referring to IRS 929 to determine which standard deduction a dependent can take which says on the definitions page : Earned income
Salaries, wages,tips, professional fees, and other amounts received as pay for work actually performed. For purposes of determining a dependent’s standard deduction, earned income also includes any part of a scholarship or fellowship grant that the dependent must include in his or hergross income.
As I said before, OP should probably read the stuff, work alone or with a professional and just keep all the stuff to show the reasoning. The earnings portion of the 529 distribution is the part we are all talking about, and it usually won’t be all that high, but so much depends on the family income, student income, scholarships, amount taken from the 529. What works for one situation probably won’t work for another.
You can google this all day and get contradicting opinions from tax experts (especially on the question of taking out to offset a scholarship and whether that has to occur in the same year as the scholarship was awarded.) Because of that, we decided to follow the IRS instructions and flow charts, pay taxes, and move some but not all money out while she was in school to avoid the penalties. Now she’s in graduate school but still fully funded, she is now independent, and some money is still in the 529.
In the end, you do your best, pay some taxes, and keep all your paperwork. Definitely don’t take any advice besides that from me.
Right, but the taxable portion is listed on the student’s own tax filing under other income Line 1a and treated as taxable income in the taxing part on the student’s form. (rather than as investment type income).
Because dependent or not, 529 or none, if they are getting room and board, it is likely they need to pay taxes on that “income” but the standard dependent deduction goes up per the 929 definition. I think.?
Yes the standard deduction goes up, but if you exceed it, even with additional earned income, then the remaining amount is taxed as unearned income.
We had to set up a small deductible IRA for D last year to avoid kiddie tax when her part time job took her total 2021 income over the standard deduction. We’ll now unwind that this year and convert it to a Roth while she’s low income and not subject to kiddie tax.
telephones, insurance, transportation home, summer living at home, car, clothing, vacations. Some scholarships don’t include room and board
Not every kid will have these paid by parents. Mine didn’t as she’d always paid her own phone, didn’t live at home even in the summer, had insurance through the school (which we did pay for).
When she got a job her senior year, plus her post grad earnings, she was definitely over the 50% threshold of supporting herself. She probably was for the year before that too as she earned money in the summer and her overall expenses were pretty low so to get to the 50% mark didn’t take much in earnings (and the other expenses weren’t coming from me, but from her jobs and student loans).
. Plan is to leave funded to ensure no need for graduate school but the Roth IRA option is very intriguing . . . need to read more about it. Is it only for the beneficiary or can you deposit for the owner? Income limits? I assume back door Roth contribution won’t work since you have to first deposit into contributory IRA which may trigger withdrawal penalty.