Dear Dr. Don, I have two sons currently in college. I am tapping Section 529 plan accounts to pay their fees. When I withdraw, say, $1,000, the fund pays it out as, say, $800 from contributions and $200 from earnings. When I determine the taxability, should the qualified higher education expenses, or QHEE, be greater than $200 or should it be greater than $1,000 for the entire withdrawal to be tax-free? -- Abe Accounts
Dear Abe, Greater than $1,000. When you take money out of a Section 529 plan to pay qualified educational expenses, all of the money distributed has to go toward the expenses to get the tax benefit. The breakdown you get from the plan is useful in computing your taxes because it's the investment earnings that are free of federal income taxes.
The plan is required to provide you with a Form 1099-Q, Payments from Qualified Education Programs, from each of the plans from which you received a 529 plan distribution in a tax year. The form should be sent to you by Jan. 31.
The contributions were taxed on the way into the account. They're not taxed on the way out. You still need to spend the contributions when distributed for qualified educational expenses to get the tax break on the investment earnings used for qualified expenses. If you withdraw more than the qualified expenses, the excess is considered a nonqualified distribution. If you take the money out and don't spend it on qualified distributions, the distribution will be taxed. In general, taxable distributions also are subject to a 10% penalty tax on the amount included as taxable income.
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 529 plan distributions for the tax year to the adjusted qualified education expenses.
With a child in college myself, I'm having a hard time figuring out why you feel the need to try to finesse distributions out of the 529 plan for anything other than qualified expenses for your two college students. Don't try to game the IRS on this one.