Section 529 Plans: Filing Tax Returns and Reporting Contributions

Reporting contributions: Income Tax versus Gift/GST Tax

Very little in Section 529 qualifies as easy to understand — but this does. There is no current federal income tax deduction for contributions made into a Section 529 plan. You don't need to disclose to the IRS that you have a Section 529 plan on your income tax return (your Form 1040, 1040A, or 1040EZ). It doesn't matter how much money you earn; if you have the money to put into a plan, you can contribute it, no matter your income.

Finally, there's no limit to how much you can contribute in a single year or how many plans you can fund. If you have six potential students you want to put through college, you can. You can even fully fund a plan, any plan, and as many plans as you want, in one lump sum, up to the stated plan limit, in a single year, although you may have gift and/or Generation-Skipping Transfer (GST) tax considerations.

The rules regarding reporting contributions for gift and GST tax returns are a bit more complex, and you may decide early on to seek professional advice. Smart choice! However, here's a quick overview:

• If you make gifts of less than $13,000 in 2009 to any one person (including the contribution you make into a Section 529 plan for that person), even if that gift isn't to your child, you don't need to file a Form 709, the U.S. Gift (and Generation-Skipping Transfer) Tax return.
• If you make contributions into a Section 529 plan of between $13,000 and $65,000 for a single designated beneficiary, you need to file a Form 709 for this year, and for the next four years if you make any additional gifts in those years. In each year, you show the total amount of the gift and the amount of the gift eligible for annual exclusion status. If the amount that you give is less than $65,000, then you will report one-fifth of the total amount in each year. You make this election on the tax return itself, which is due at the same time as your income tax return. You need to make the election only once, in the first year; in the subsequent four years, if you don't make other taxable gifts, you're not required to file a Form 709 for those years. If you're gift splitting with your spouse, both of you need to file a Form 709 in the first year, and both of you need to make the election for spreading the gift over five years.
• If you make contributions into a Section 529 plan in excess of $65,000 in any single year for any single beneficiary — or $130,000 if you can split the gifts with your spouse  — you can still elect to spread $65,000 over five years. The balance of the amount over $65,000, though, is entirely taxable in the year the gift is made. Be certain to make the proper election on your gift tax return to get the five-year treatment.
• When you contribute an amount that's in excess of the annual exclusion amounts to a 529 plan for a beneficiary who isn't your child, you need to know where this person fits on the generational scale, for Generation-Skipping Transfer Tax (GSTT) purposes. If the person is your relative, this is easy to figure out " your children's children constitute one generation skipped, your niece's child is one generation skipped, and so on. If the designated beneficiary is not related to you, the generations are calculated by using your age as the benchmark as follows:
• For someone born not more than 12 and a half years after you, he or she is considered to belong to your generation and is therefore not a skip person.
• For someone born between 12 and a half and 37 and a half years after you, he or she is considered to belong to the same generation as your children and is therefore not a skip person.
• For someone born between 37 and a half and 62 and a half years after you, he or she belongs to the same generation as your grandchildren. Gifts made into a Section 529 plan also qualify for GSTT treatment.

Whenever you make a gift larger than your annual exclusion amount to anyone who is more than one generation removed from you, that gift becomes subject to the gift tax and the GSTT rules.

Reporting Distributions

After you figure out the contribution reporting requirements, you need to know how and where to report distributions, both qualifying and nonqualifying, for income tax purposes.

When you receive any distribution from a Section 529 plan, the plan manager is required to furnish to the person receiving the distribution (or the person on whose behalf a distribution is made) a Form1099-Q by January 31 of the following year. On this form, you'll see the total distribution in Box 1, the earnings portion in Box 2, and your basis (the amount you contributed over the years) in Box 3. Box 2 and Box 3 added together should equal the amount in Box 1.

The good news is that, although you'll receive this form, you determine what, if any, of your distribution is taxable. If you know for a fact that the total distribution made to you paid for qualifying educational expenses (if the plan wrote the check directly to your college or university, that's a safe bet), then all you need do is keep the 1099-Q safely stored with the rest of your tax information so that you can defend your position if any question arise later.

If, however, you know that some or all of the distribution was not used for qualifying expenses, then you need to sit down, do some calculations, and arrive at the amount of taxable income you should include on the line labeled "Other Income" on your Form 1040.

For example, say a student received a distribution from his parents' Section 529 plan for $20,000. He also received a scholarship in the amount of $2,000. His qualifying expenses at his university were $15,000. Box 2 of his 1099-Q shows $3,500, while Box 3 shows $16,500. To arrive at his taxable income from this distribution, he must make the calculation shown in Figure 6-2.

Figure 6-2: Figuring out taxable income from a 529 distribution.

Because, in this example, the parents have distributed more than the amount of qualified educational expenses to their student, he pays tax on the earnings portion of the nonqualified distribution. In addition, he also pays the 10 percent penalty on the earnings included in the amount of nonqualified distribution he would have received if he didn't have the scholarship (in other words, he's not penalized for someone giving him free money).

Reporting For Purposes Of Future Financial Aid Awards

Just like no two Section 529 plans are identical, the response to how these plans affect financial aid awards varies widely and by type of plan.

Currently, distributions from prepaid tuition plans seem to have the most adverse effect on need-based financial aid packages, as each dollar you take as a distribution is currently offsetting one dollar of potential aid. The states are clearly looking at prepaid tuition plans as a direct reduction in the cost of attending an institution, and not the plan owners' assets, and are assessing payment ability accordingly.

Savings plans are currently being treated completely differently under the federal formula used to determine need-based aid eligibility. They are considered an asset of the plan owner and are therefore counted as a parent asset if the parent is the account owner and as a student asset if the student is the account owner. A plan that is owned by Grandma Ida, for example, is not even looked at when the student applies for federal financial aid, although it may be if the aid is coming directly from a specific college.

Because your student needs to apply for financial aid for each academic year that he needs assistance, the receipt of any nonqualifying distributions from a 529 savings plan in one year may result in a smaller need-based aid award in the subsequent year or years. It appears however, that, so long as distributions are made only for qualifying expenses (and therefore the student doesn't need to declare any income from the distribution on his or her income tax return), the distributions won't affect subsequent aid eligibility under current rules.