I recently received the following reader question:
My daughter received college scholarships in 2019. I had the 529 plan distribute funds equivalent to the scholarship amounts directly to her. My daughter is the beneficiary and I am the owner of the plan. Who will be responsible to pay for the taxes related to the distribution?
Although most people call these accounts a 529 plan, the IRS calls them a “qualified tuition program” or QTP in both their publications and on their forms. I normally use the term 529 plan. However, both terms will appear in this article as I am often quoting the IRS forms or publications. The two terms are interchangeable.
Who is Responsible?
For any tax year when a 529 distribution is made, the 529 plan custodian will issue a 1099-Q to report the distribution to the IRS. The individual noted as the recipient on the 1099-Q is responsible for either demonstrating that the funds were qualified distributions or including the distributions on his or her tax return and paying any necessary tax or penalty.
As the 1099-Q instructions for the custodian state, “List the designated beneficiary as the recipient only if the distribution is made (a) directly to the designated beneficiary, or (b) to an eligible educational institution for the benefit of the designated beneficiary. Otherwise, list the account owner as the recipient of the distribution.”
This means that if the recipient of the 529 distribution was either the designated beneficiary or the educational institution directly, then the 529 beneficiary will receive the 1099-Q. Otherwise, the account owner will receive the 1099-Q.
In the case at hand, the reader says that the 529 funds were distributed to the beneficiary directly which means that she will receive the 1099-Q and be responsible for either demonstrating that the funds were qualified distributions or including the distributions on her tax return and paying any necessary tax or penalty.
How Do You Calculate Qualified Education Expenses?
The 529 plan custodian has no way of knowing whether this distribution is qualified or non-qualified, so none of that information is included on the 1099-Q. Instead, the burden of calculating qualified education expenses and thus calculating the taxable and non-taxable portions of the 529 distribution is solely the responsibility of the tax payer.
Qualified education expenses include tuition and fees; books, supplies, and equipment; expenses for special needs services as required by a special needs beneficiary; expenses for room and board, so long as the student is enrolled at least half-time; the purchase of a computer, peripheral equipment, software, internet access, and “related services;” and lower education tuition. For the most accurate list, you can review the qualified tuition program (QTP) section of IRS Publication 970.
Although there is no form to report your qualified education expenses on, if you get audited you will need to be able to produce a clear calculation and a list of receipts. For this reason, it is best practice to save a document that contains all of the justification for your calculation. This is easiest done electronically with scans as receipts tend to fade in a matter of months and you will need to save these records essentially forever.
How Do You Adjust Qualified Education Expenses?
As Publication 970 states:
Figuring the Taxable Portion of a Distribution
To determine if total distributions for the year are more or less than the amount of qualified education expenses, you must compare the total of all QTP distributions for the tax year to the adjusted qualified education expenses.
Adjusted qualified education expenses.
This amount is the total qualified education expenses reduced by any tax-free educational assistance. Tax-free educational assistance includes:
- The tax-free part of scholarships and fellowship grants (see Tax-Free Scholarships and Fellowship Grants in chapter 1);
- Veterans’ educational assistance (see Veterans’ Benefits in chapter 1);
- The tax-free part of Pell grants (see Pell Grants and Other Title IV Need-Based Education Grants in chapter 1);
- Employer-provided educational assistance (see chapter 11 ); and
- Any other nontaxable (tax-free) payments (other than gifts or inheritances) received as educational assistance.
This means that after calculating all of your qualified education expenses, you need to subtract any tax-free educational assistance received from that number.
For example, if you received a tax-free scholarship that exactly covered tuition, then the tuition would be included as a qualified education expense but the scholarship would be subtracted from total educated expenses, effectively excluding tuition from the calculation.
After the subtraction, this is your adjusted qualified education expenses.
Sometimes students receive grants which are intended to cover all expenses. It is possible that such all-inclusive tax-free assistance could be so large as to create a $0 or even negative adjusted qualified education expenses.
It is also possible that even with a generous scholarship, you still have qualified expenses leftover.
It is best practice to make this calculation before you reimburse yourself, so that you can distribute just an amount equal to the expenses not already reimbursed and leave behind the remaining 529 plan funds in the account.
How Do You Calculate Qualified Distributions?
After calculating the adjusted qualified education expenses, compare this amount to the total amount distributed from education accounts for the beneficiary. You can find the total distribution amount on 1099-Q box 1 or potentially by summing the 1099-Q box 1 for multiple accounts that benefit the same beneficiary.
If your total distributions for that beneficiary exceed that beneficiary’s total adjusted qualified education expenses, then you will likely owe tax and maybe a penalty.
The excess distributions beyond the adjusted qualified expenses are the non-qualified distributions from which you will calculate the taxable portion.
Note that 529 plan rollovers are sometimes included in 1099-Q’s figures if a rollover contribution strategy was utilized. However, rollovers are generally not taxable. As Publication 970 states:
Any amount distributed from a QTP isn’t taxable if it’s rolled over to either:
- Another QTP for the benefit of the same beneficiary or for the benefit of a member of the beneficiary’s family (including the beneficiary’s spouse), or
- An ABLE account for the benefit of the same beneficiary or for the benefit of a member of the beneficiary’s family (including the beneficiary’s spouse). But this doesn’t apply to the extent the amount distributed when added to other amounts contributed to the ABLE account exceeds the annual contribution limit. For more information about ABLE accounts, see Publication 907, Tax Highlights for Persons With Disabilities.
You can read more about 529 rollovers in “Requirements for 529 Accounts (Qualified Tuition Programs).”
How Do You Calculate the Taxable Portion?
If you have the portion that is a non-qualified distribution, you now need to figure out the taxable and nontaxable portions. Luckily, only the portion of the excess distribution that is attributable to earnings is taxable. The portion that is attributable to the contribution basis is nontaxable.
As Publication 970 states, “The part of a distribution representing the amount paid or contributed to a QTP doesn’t have to be included in income. This is a return of the investment in the plan.”
IRS Publication 970’s instructions for this calculation are:
Use the following steps to figure the taxable part.
- Multiply the total distributed earnings shown on Form 1099-Q, box 2, by a fraction. The numerator (top part) is the adjusted qualified education expenses paid during the year and the denominator (bottom part) is the total amount distributed during the year.
- Subtract the amount figured in (1) from the total distributed earnings. The result is the amount the beneficiary must include in income. Report it on Schedule 1 (Form 1040) or Form 1040NR, line 21.
In other words, take the student’s total adjusted qualified education expenses (expense minus tax-free assistance) divided by the student’s total distributions (1099-Q Box 1) to get the percentage of the distribution which was qualified or nontaxable.
Then, multiply that percentage times the portion of the distribution that was earnings (1099-Q Box 2). This gets the portion of the earnings which is nontaxable.
Next, subtract from the earnings (Box 2) the amount that is nontaxable (calculated above) to get the portion that is taxable.
This taxable amount is then the amount that should be included on your tax return.
Where Do You Report the Taxable Portion on Your Tax Return?
After having calculated the taxable portion, which again is only sourced from the earnings portion of the distribution, the next step is to report it on your return.
There is no special designated spot for taxable 529 distributions at this time. Thus, this taxable portion should be included on Schedule 1 line 8 “Other Income” with a description of the income type written in the corresponding blank space.
Where Do You Pay the 10% Penalty on Your Tax Return?
Unless you have an exception, your taxable portion also needs to be reported on Form 5329 Part II “Additional Tax on Certain Distributions From Education Accounts and ABLE Accounts.” The exceptions as described in Publication 970 are:
Generally, if you receive a taxable distribution, you also must pay a 10% additional tax on the amount included in income.
Of note for this reader is #3, if the distribution was included in income only because the beneficiary received tax-free assistance and their distribution is equal to or less than the tax-free assistance, then you have an exception from the penalty even though the earnings portion will still be included in income.
Regardless of whether you have an exception, the taxable portion is reported on Form 5329 line 5.
Then, on line 6, you note the taxable amount that is excepted from the 10% penalty.
Line 7 is then a simple subtraction to remove the excepted portions, and the final adjusted number is multiplied by 10% to calculate the penalty owed on line 8.
This extra penalty is then included on Schedule 2 line 6 “Additional tax on IRAs, other qualified retirement plans, and other tax-favored accounts.”
In this way, non-qualified 529 distributions only have the earnings portion taxed and although it is likely subject to the 10% penalty, this particular reader may be off the hook for that penalty.
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