When you follow the rules and guidelines on how to use your 529 plan, money in the account does not count as income on your taxes. You do not report the distributions as income. However, if you accidentally use the funds on ineligible expenses or make a withdrawal, the 529 distribution may be subject to a penalty fee and taxes.
The following are cases in which your distribution may be counted as income.
The Distribution is Spent on Ineligible Expenses
Tuition, books, computers, printers, internet, necessary school equipment, and room and board are considered qualified expenses for the 529 plan. Purchases that are not considered eligible expenses include sports and club memberships, insurance, transportation, and mobile phone fees. For example, let’s say that your membership in an intramural sports team is listed among the fees and expenses on your tuition bill. If a portion of your distribution is used to pay for the sports membership, it’s an ineligible expense and that amount is considered taxable income.
You Withdraw Money and it is Not Contributed to a Qualifying 529 Plan Within 60 days
If you wish to rollover a 529 account or close your account and open a new plan, you can withdraw the funds and send a check for that amount to the new plan. However, if the money is not deposited into a 529 plan within 60 days, the amount will be regarded as taxable income.
You Exceed Qualified Higher Education Expenses (QHEE)
Perhaps the most innocent way that a distribution would qualify as income is by exceeding your Qualified Higher Education Expenses (QHEE). Each year your college estimates the cost of attendance, which includes tuition and fees and estimates for room and board. Two ways that account holders inadvertently exceed this expense:
The 529 plan is used to purchase off-campus housing that exceeds the university’s estimate for room and board. 529 plans can be used for off-campus housing, but the cost must not exceed university estimates.
Tax-free aid such as grants and scholarships are not deducted from expenses. After calculating expenses based on tuition and fees, room and board, and other qualifying costs, you must deduct the amount of any grants, such as the Federal Pell Grant or scholarships. The remaining amount can be paid with the 529 plan.
In this case, the beneficiary of the 529 plan would receive an IRS Form 1099-Q and would be responsible for paying the taxes on the amount that exceeds the QHEE. In most cases, the beneficiary will have a lower tax bracket than the account holder, so the tax is not substantial.
You Take too Many Credits
In addition to using the 529 plan, you may take the Lifetime Learning Credit or the American Opportunity Tax Credit (AOTC) for qualifying educational expenses. However, taking either credit can lead to a surplus that exceeds your QHEE. If you exceed the qualified expenses, the money withdrawn from the 529 plan may be subject to income tax.
What are the Taxes and Penalties?
Distributions that are not spent on qualifying expenses through one of the scenarios above will be subject to a 10% federal tax penalty and subject to both state and federal income taxes. The tax penalties are waived if the beneficiary receives a scholarship, attends a military academy, is disabled, or dies. In these cases, the distribution is considered taxable income. It’s also important to note that income taxes are not levied on the entire distribution, but only the earnings portion. Because 529 contributions are made with after-tax dollars, they cannot be taxed. Therefore the amount of tax due depends on the earnings on the account.