Posted on August 28th, 2021
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.
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.
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.
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.
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.
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.
Using the numbers below as an example, you can see how this person could withdraw $4,000 tax-free:
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.
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.
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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