529s and Taxes - To Report or Not to Report?

Education

Posted on March 19th, 2024

Invite loved ones to contribute to your 529 plan

In a past blog we talked about how to make a withdrawal from your 529 plan, if you missed it, check it out here. You definitely want to read the info in that blog BEFORE submitting a withdrawal distribution to make sure you withdraw the right amount to avoid penalty.

Today we're tackling the next (and probably most dreaded) step of your educational savings journey-- figuring out if and how you need to report your 529 distribution on your tax return.

The good news is, if you're paying your educational institution directly from your 529 plan, and you withdrew exactly the amount you need for any additional qualified expenses, you should be in the clear and you won't need to report anything on your tax return. Woohoo!

If you have scholarships and tax-credits to consider, or spent the funds on non-qualified expenses, you might need to do a little math to make sure there are no taxes owed. Fear not, despite all the tedious form names and acronyms, it's actually pretty simple, but there are some rules to keep in mind.

Form 1099-Q

When you withdraw a distribution of funds from your 529, the recipient of the distribution (best practice is that this is the beneficiary) will be issued with a Form 1099-Q by your 529 plan administrator. This form lists the total distributions from your 529 plan for the tax year, this includes funds that were spent on non-qualified expenses (if any).

On the form there are typically 3 sections, showing the total distribution, the earnings portion of that distribution, and the principal (your initial contributions) portion of the distribution. If you spent the money on a non-qualified expense, your taxes and 10% penalty will be only applied to the earnings portion of your distribution.

Keep those Receipts

Form 1098-T is issued by a college or eligible educational institution and it lists the dollar amount paid for tuition, fees and course materials required for enrollment. This form is used to determine the eligibility for various tax credits and also serves as proof that the funds from your 529 plan were spent on eligible expenses.

For all qualified expenses that Form 1098-T does not list - like room and board, computers and internet access, apprenticeship programs, student loan payments, or K-12 tuition - you will need to ensure you keep your receipts and calculate your total eligible spend for the tax year by adding these expenses to those listed on Form 1098-T.

If the 529 funds are used on non-qualified expenses, the earnings portion of the distribution will be subject to tax (as with regular investments) plus a 10% penalty.

Calculating your Adjusted Qualified Educational Expenses

Now that you have all your expenses and receipts organized, if you haven't already, now it's time to calculate your Adjusted Qualified Educational Expenses (AQEE). Ideally you'd want to calculate this prior to making a withdrawal to ensure you don't withdraw more funds than you need.

If the parent (or account owner) qualifies for American Opportunity Tax Credit (AOTC) or Lifetime Learning Tax Credit (LLTC), or if the child (or beneficiary) receives a tax-free scholarship, Veterans assistance, or any other tax-free educational assistance, don't forget to take this into consideration when calculating your eligible expenses. As with pico de gallo at a barbecue, double dipping into tax-free benefits is a big no-no.

Step 1: Itemize and add up this tax year's qualified educational expenses.

Step 2: Subtract any tax-free assistance you might have (this includes tax-free scholarships, veteran's assistance, and educational assistance through a qualifying employer program).

Step 3: Subtract any expenses used to generate your AOTC or LLTC if you're claiming them.

Using the numbers below as an example, you can see how this person could withdraw $4,000 tax-free:

Step 1: This year's qualified expenses total $10,000

Step 2: Your child won a $2,000 tax-free scholarship

Step 3: You use $4,000 to generate your AOTC

$10,000 - $2,000 - $4,000 = $4,000 AQEE

Pro Tip: Don't forget to account for any refunds you might get from the school. If the student changes a course, or drops a class after tuition is paid, and it results in a refund from the school, you need to re-contribute that refund back into the 529 plan within 60 days to avoid taxation and penalty.

10% Penalty and Exceptions

If you use the funds on non-qualified expenses, or if you didn't calculate your AQEE before requesting your withdrawal distribution and you accidentally withdrew more funds than calculated in your AQEE, the earnings portion on the amount of excess funds you withdrew will be subject to income tax and the 10% penalty.

While the earnings of all non-qualified withdrawals are subject to tax (as with any regular investment), there are instances where you won't be subject to the 10% penalty. This includes scholarships, attending a U.S. Military Academy, tax-free educational assistance, receipt of education tax credits, the return of excess funds that were previously withdrawn in error, death or disability.

Do You Need to Report Your 529 Distribution?

If you withdrew an amount equal to or less than your AQEE and you used the funds on qualified educational expenses, you won't have to report anything. High five!

Keep those receipts and all financial records in case you get audited by the IRS, but at this stage, you don't need to provide any proof of qualified expenses, or report your 529 distribution on your tax return.

Pro tip: Remember in our previous blog we mentioned it's always best to have distributions paid directly to the educational institution or to the beneficiary? This helps you to avoid the hassle that comes with an automated computer matching issue that can happen if the account owner receives the distribution.

If your 529 withdrawal is distributed to the account owner, you will need to check a box on Form 1099-Q that states that the recipient of the distribution was not the beneficiary of the plan. If this box is checked, there have been cases where IRS computers will automatically send out a deficiency notice. Correcting this will involve a lot of paperwork and headaches.

Calculating What Needs to be Reported on your Federal Tax Return

You only need to report the earnings portion of a taxable 529 distribution on your tax returns. This means, only the earnings portion of funds that were withdrawn in excess, or used on non-qualified expenses.

Step 1: Divide your AQEE by the total 529 distribution you withdrew. (You can find this distribution amount on Form 1099-Q in Box 1.)

Step 2: Multiply your answer by the earnings portion of the total distribution. (You can find this earnings amount on Form 1099-Q in Box 2.)

Step 3: Subtract your answer from step 2 from the total distributed earnings. This is the amount that needs to be reported on either the 529 account owner or beneficiary's tax return. Not both!

Where to Report Your Taxable 529 Distribution

If you need to report a taxable 529 distribution, it will be on the tax return of whomever received the funds and received Form 1099-Q. It will be reported on line 8 of Schedule 1 Form 1040, or line 21 of Form 1040NR.

If you need to report a 10% penalty, it will be reported on line 6 of Schedule 2 Form 1040, or line 57 of Form 1040NR.

And that's it! Deep breath. You did it! Let's be honest, filing taxes is a chore, no matter how you look at it. But if you know the rules and do a little prep work, it doesn't need to be stressful.

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