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Section 529 Plans: Filing Tax Returns and Reporting Contributions (page 2)

By — John Wiley & Sons, Inc.
Updated on May 28, 2014

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.

 

 Total qualifying educational expenses  $15,000
 SUBTRACT: Scholarship amount  -2,000
 Net qualifying educational expenses  $13,000
 Total distribution from Section 529 Plan  $20,000
 SUBTRACT: Net qualifying educational expenses  −13,000
 Total nonqualifying distribution from Sec. 529 Plan  $7,000
 Ratio of nonqualifying to total distribution  $7,000/$20,000 = 35%
 Taxable portion of nonqualifying expenses  $3,500 × 35% = $1,225

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.

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