If your kid receives a scholarship they can take that amount as a distribution from their 529, to save for another purpose later that might not be educational in nature. There is no penalty for doing this, but the earnings portion of the distribution is considered taxable income.
This we knew, but had read multiple places that it would be taxed at HER tax bracket, not ours. This is not true. A dependent’s interest income over ~$2200 is taxed at the parents rate. This is the case whether you claim your kid as a dependent or not (we do not, she claims herself).
Example: D takes a distribution from her 529 in the amount of $12000-- the amount of her scholarship. Of this about 60% is interest and 40% is principle. So $7200 is taxable income. She gets $2200 at her rate of 10% and the remaining $5000 at our highest rate of around 40%. This was true for both federal and state taxes. (She also had regular income and did take the standard deduction and tax credit, but the above scenario operates fairly independently of all that I think as it not earned income.)
So now she has a huge tax bill as our rate is 4x her rate. We will not take the distribution again next year, but wish we had known how this really works. (Please do all your own due diligence as this stuff changes every year and I am obviously not a tax professional.)
Also of note:
Do not use your 529 to pay for college required medical insurance. You will pay the penalty if you do. It is not allowable.
If you need to purchase allowable items like books, computer, etc., the student themselves should make these purchases and file for the 529 distribution to come to them directly. If the parent pays we think the 529 distribution is still valid but it makes for some very messy tax forms.
This is a topic I have been searching about for over a year and there’s very little information out there, especially nothing reliable or specific. I hope this helps someone avoid these pitfalls. It was an expensive lesson learned for us.
Fwiw, I’ve always had distributions come to me and have never had issues with tax forms. Total distributions go on one form and the same number goes as total expenses on another form. Just keep receipts, as always.
I would think this would be easier than two 1099-Q’s going to different people to be filed on different forms, but I never had to deal with doing this.
Our disbursement was allowable and we didn’t pay a penalty, but we did have to pay taxes at our rate, not our daughters rate. That was the surprise. It would be better for her to wait and pay the penalty and her tax rate later upon graduation when she is no longer a dependent.
No - i’m asking is it possible that the tax on the gain of taking out (to match a scholarship) is charged at your daughter instead of your rate - when it’s your account, not hers.
Leave it to the feds to come up with a great program - if and only if you use it one way. Otherwise it’s a disaster because there are so many interpretations on line about 529 and when you can claim $. Some say same year. Some say within the 4 years. Others say, it’s intended for this but there’s actually no rule.
So, for scholarship: would it make sense to only withdraw $2200 (as an allowable disbursement) even when the scholarship is much bigger than that? Or do we need to do some calculation involving principal versus taxable earnings/interest, so that the taxable portion is $2200 but the actual amount withdrawn is larger than that? The scholarship is over $25000. Was thinking we were allowed to take the withdrawal free and clear. (All numbers I’m posting are per year). Thanks for the warning! And yes the child is the beneficiary but accounts are in my name.
Assuming your student has no other unearned income, then you should try and figure out how to take a disbursement such that the interest amount is $2200 or less. You will not be taxed on the principle portion of the disbursement.
This is exactly where we screwed up— we took out $13000k plus she had other earnings on a trust fund, so it was about $16000 total unearned income and she has to pay the highest tax rate on most of it.
Yes…this is the Kiddie tax. And it doesn’t matter if your student files themselves or not…
“ It doesn’t matter whether the child is claimed as a dependent on the parent’s return . However, the tax does not apply to a child under 24 who is married and files a joint tax return.”
Thanks. The info is a bit confusing b/c it seems to imply that filing your own return as a student can avoid you paying at your parents tax bracket. This is only true if you also supply >50% of your living expenses. My D files her own return and we do not claim her as a dependent, but she does not meet the 50% mark, and thus still pays unearned income tax at our rate.
I understand the intent of this tax law but it really sucks for 18+ college students who are just trying to save up a bit to get a start in life.