Avoid Tax Trap on 529 Withdrawals

If you’re like many parents of children in college, your kid is currently learning remotely from home, even though you signed up for room and board at the school.

Watch out for a hidden tax trap. If you’ve withdrawn funds from a child’s Section 529 plan and don’t return them, you could be hit with an unexpected tax bill.

To add insult to injury, the IRS can tack a 10% penalty tax onto the amount that you owe.

A Section 529 plan is an education savings plan operated by one of the states. As long as certain requirements are met, there’s no income tax on the accumulation of earnings within the plan, plus qualified distributions are exempt from tax. Furthermore, contributions to the plan may be sheltered from gift tax by the annual gift tax exclusion.

The list of qualified expenses includes:

  • Tuition: This qualifies for both full-and part-time students at accredited institutions.
  • Room and Board: As long as the student is attending college at least half-time and room and board are paid directly to the school, it’s a qualified expense.
  • Technology Items: A 529 plan can be used to cover items like computers, printers, laptops and even Internet service.
  • Books and Supplies: These are qualified expenses if the school requires them.

Caution: You may have withdrawn funds to pay for anticipated room and board or other anticipated qualified expenses, but now the expenses won’t be incurred due to COVID-19 related fee refunds or room and board costs because your child is living at home instead of in the dorm.

Refunds of qualified expenses must be re-contributed to the 529 account within 60 days to avoid being taxed on the amount of the 529 withdrawal that is no longer needed due to the refund(s). There will also be a 10% tax penalty on the amount that consists of earnings.

Tip: If you’re returning money to a 529 account, be sure it’s characterized as a recontribution due to a refund of qualified expenses.

Small Business Tax Strategies
December 2020