529 Essentials: Qualified Distributions & 10% Penalty Exemptions

This week’s 529 Essentials covers qualified distributions and exemptions to the 10% penalty for non-qualified distributions. As a quick recap on last week’s 529 Primer article, money in 529s grow tax-free and distributions are tax-free when used for qualified higher education expenses such as tuition, room and board (if registered as a student at least half-time) and other qualified higher education expenses at eligible schools. Also, the qualified distributions need to take place in the same year as the qualified expenses. Otherwise, the gains portion of the distributions are subject to a 10% penalty and taxes. Additionally, any state tax benefit received from making the contribution would typically need to be paid back to the state. This process is called a tax recapture. While non-qualified distributions with or without the exemptions will result in paying taxes on the gains and potentially a tax recapture on the initial amounts put into the account over time, there are certain scenarios called exemptions where one would not have to pay the 10% penalty. For example, the beneficiary would be exempt if they:
– Die
– Take a distribution due to disability
– Attend a U.S. military academy
– Receive (up to amount of the distribution):
—- Tax-free scholarship or fellowship grant
—- Veterans’ education assistance
—- Employer-provided educational assistance
—- American Opportunity and Lifetime Learning Credits

Beneficiary changes. If the accountowner does not qualify for any of the exemptions, one solution could be to change the designated beneficiary to another member of the beneficiary’s family that they do expect to attend college or a graduate degree, such as a brother or sister, daughter or son, father or mother, or grandparent of the beneficiary. As a result, no taxes or penalties would be created as a part of the transition.

Rollovers. Also, on a related subject of changing plans without penalties or taxes, the accountowner can change between 529 plans for the same beneficiary 1 time within a 12 month period.

Recontribution of Refunded Amounts. Lastly, one new functionality effective in 2015 is that accountholders can recontribute the distributed money from the 529 account back into the account within 60 days to avoid the penalty, income taxes and state tax recapture. This functionality can help if a parent notices within 60 days that the distributions that they just took from an account align with qualifying expenses that took place in the prior year. Lastly, the balance in a 529 plan can be used later by the current designated beneficiary for graduate school, or for a parent, aunt or uncle of the designated beneficiary looking to go back to school. Therefore, advisors should ensure that money in 529s are only taken out for qualified expenses, or in careful coordination of an exemption, beneficiary change or rollover. Next Week, we will cover state tax benefits.