ACA and non-qualified 529 withdrawals?

[RetiredAt55.5]

I'm planning on making some non-qualified 529 withdrawals for 2022. I know I'll have to pay taxes on the withdrawals.

However, I'm not sure how the withdrawals will affect my income for subsidy purposes. Would just the gains be treated as additional investment income, or would the entire withdrawal amount be considered income?

Anyone have any first hand experience doing this?

 

[SecondCor521]

[-]You'll[/-] The student will only have to pay taxes on the earnings portion. If [-]you[/-] the student does not qualify for an exception (scholarship, service academy, death, etc.), there is also a 10% penalty, again only on the earnings portion.

[-]Your[/-] The student's 1099-Q from your 529 custodian which [-]you[/-] they receive will show [-]you[/-] them the total withdrawal and earnings portion. [-]You'll[/-] They'll have to do some math (explained in Pub 970 Chapter 8) to allocate between qualified and non-qualified distributions.

The end result of the above math will end up as Other Income on line 8z of [-]your[/-] the student's Form 1040 Schedule 1. This amount will flow into [-]your[/-] the student's AGI and reduce [-]your[/-] their subsidy (if any). Depending on [-]your[/-] their AGI in relation to FPL, [-]you'll[/-] they'll lose about 15 cents of every dollar of subsidy for that Other Income.

ETA: Fixing text per my next post below. It affects the student's return, not the parent's.

 

[RetiredAt55.5]

Your 1099-Q from your 529 custodian which you receive will show you the total withdrawal and earnings portion. You'll have to do some math (explained in Pub 970 Chapter 8) to allocate between qualified and non-qualified distributions.

The end result of the above math will end up as Other Income on line 8z of your Form 1040 Schedule 1. This amount will flow into your AGI and reduce your subsidy. Depending on your AGI in relation to FPL, you'll lose about 15 cents of every dollar of subsidy for that Other Income.

So, just so I understand completely, let's say all my 2022 529 withdrawals are non-qualified, I withdraw $12,000 and the earnings are $4,000.

Is the other income on line 8z $12,000 or $4,000 ?

 

[SecondCor521]

So, just so I understand completely, let's say all my 2022 529 withdrawals are non-qualified, I withdraw $12,000 and the earnings are $4,000.

Is the other income on line 8z $12,000 or $4,000 ?

It would be $4,000. The other $8,000 is return of your contributions and is not considered taxable income.

Your ACA subsidy, on average, would decrease by about $600 - could be a bit more or much less depending on what else is going on with your tax situation next year. But see the following paragraph!

Oh, except one other thing I forgot to mention earlier (sorry): The way I read Pub 970 Chapter 8, the Other Income should go on the student's return, not yours. One benefit of this is that the student is probably in a lower tax bracket than you are. If you have a graduating senior who might make more money next year, you might want to do the distribution this year so that it shows up on the student's 2021 tax return when they are a relatively low-income college student.

I did that last year with my graduating senior. Distributed about $9K NQ from his 529, put the Other Income calculated amount on his tax return (per Chapter 8 Pub 970), and it ended up being effectively tax free because it was below his standard deduction (he was 25 at the time so a tax independent). This year with his full time job he might be somewhere into the 22% bracket, so we saved 22% of that distribution's earnings.

As an aside, the other thing to look out for tax-wise is whether your state might claw back any state deduction that you received when you made those contributions. This is probably unlikely. It only might be an issue if your contributions were recent, which they probably were not. And not all states claw back.

 

[skibum]

We have liquidated excess 529 accounts to graduating seniors as described, paying tax and penalties on earnings only of non-qualified distributions at the students rate. If the student is filing as a dependent of the parent, then this "other" income (and any regular income of the student), would contribute to the family ACA MAGI income, potentially reducing the ACA subsidy by up to 8.5% for MAGI > 400% of FPL.

Be advised the "other" income from non-qualified 529 withdrawals to the student is unearned income, and if in excess of $2,200, may bump a full time student age 19-24 who is NOT providing more than 50% of their own support into the "kiddie tax", at the parents tax rate, as implemented on form 8615.

 

[SecondCor521]

We have liquidated excess 529 accounts to graduating seniors as described, paying tax and penalties on earnings only of non-qualified distributions at the students rate. If the student is filing as a dependent of the parent, then this "other" income (and any regular income of the student), would contribute to the family ACA MAGI income, potentially reducing the ACA subsidy by up to 8.5% for MAGI > 400% of FPL.

Right, the dreaded "Form 8962 line 2b" issue.

Note that there is a potential to avoid it. If the student files (say, to get a refund of taxes withheld) but was not required to file (did not meet any of the items in charts B or C in "who must file"), then their AGI does not need to be added on the parents' Form 8962 line 2b.

Be advised the "other" income from non-qualified 529 withdrawals to the student is unearned income, and if in excess of $2,200, may bump a full time student age 19-24 who is NOT providing more than 50% of their own support into the "kiddie tax", at the parents tax rate, as implemented on form 8615.

Right. Annoying. My eldest avoided this by graduating from college at age 25. Another way to do this would be to have the student provide more than 50% of their own support that last year, which might be reasonable.

 

[RetiredAt55.5]

Oh, except one other thing I forgot to mention earlier (sorry): The way I read Pub 970 Chapter 8, the Other Income should go on the student's return, not yours. One benefit of this is that the student is probably in a lower tax bracket than you are. If you have a graduating senior who might make more money next year, you might want to do the distribution this year so that it shows up on the student's 2021 tax return when they are a relatively low-income college student.

I did some Google searches, and peaked at last year's 1099-Q (I have to be in the right frame of mind to look at IRS Pub's , and they seemed to concur that whoever receives the distribution (parent or child), has to declare the distribution on their taxes. I then logged onto the 529 account and see that I can withdraw money and have the proceeds go to either my son or myself (which is what I've always done in the past).

DS graduated May 2021, and got a full-time job in June. I haven't taken out any 529 distributions yet for this year, but need to by 12/31. So, it seems like I have a lot to consider both for this year and next.

In the past, only one time did I take out qualified and non-qualified 529 withdrawals in the same year. I really hated fighting with Turbo Tax to enter in the information and segregate the money. So, my initial plan (before today) was to only withdraw qualified money for 2021, and to start withdrawing all the non-qualified money over the next couple of years (so it doesn't make a big ACA subsidy impact in any year).

 

[SecondCor521]

I did some Google searches, and peaked at last year's 1099-Q (I have to be in the right frame of mind to look at IRS Pub's , and they seemed to concur that whoever receives the distribution (parent or child), has to declare the distribution on their taxes.

I'm usually in the right frame of mind to look at IRS pubs.

The above is incorrect. It's always reported on the beneficiary's tax return. In IRS Pub 970, page 61, left column, under Taxable earnings where it talks about taxable distributions from QTPs (which is the IRS term for 529s), it says:

"2. Subtract the amount figured in (1) from the total distributed earnings. The result is the amount the beneficiary must include in income. Report it on Schedule 1 (Form 1040), line 8."

-- https://www.irs.gov/pub/irs-pdf/p970.pdf, emphasis added.

Also, on your 1099-Q, look at box 6. While my SSN is listed as the recipient of the 529 distributions, box 6 is always checked. I think this is to let the IRS know to look elsewhere for any income related to nonqualified distributions.

 

[pirsquared]

I am glad that I saw this thread. I will be making a taxable withdrawal from a 529 of which I am the owner and my daughter is the beneficiary (no penalty due to scholarship). I am planning to have the money distributed to me, thus I thought it would go on my taxes. I am confused about why it would have to go on the beneficiary's return if the money is not going to her. Off to read the relevant part of Pub 970...

This could be a problem as then DD would be required to file a return, right? Currently, she is not required to file a return which means her summer job income did not need to be included in our income for ACA purposes,

 

[RetiredAt55.5]

This just seems so counter intuitive to always report the taxes on the beneficiary's tax return for non-qualified distributions that went to the owner/parent, especially when the beneficiary doesn't even receive the tax form.

So, I could leave the money in the 529 for another 10-20 years, and then make some withdrawals, pocket the money (with gains), and then my son gets to pay the taxes and extra 10% on the gains. What's not to like?

 

[pirsquared]

I just read the relevant part of Pub 970 and, while it does say that the beneficiary includes it on their return, it seems to be assuming that the money is going to them. I would feel more convinced if there was some type of language like "regardless of whether the funds are distributed to the owner or the beneficiary..."

 

[RetiredAt55.5]

SecondCor521, I agree with you that's how the Pub 970 is worded.

Here's some websites that claim the exact opposite -

https://www.savingforcollege.com/article/whose-tax-rate-applies-to-a-non-qualified-529-plan-distribution

https://www.smart529.com/smart529-details/for-account-owners/request-a-distribution/qualified-non-qualified-distributions.html

https://www.taxact.com/support/1203/2018/form-1099-q-taxable-amount-of-earnings


Note, these are the IRS instructions for the 1099-Q itself (https://www.irs.gov/pub/irs-pdf/i1099q.pdf) -

"Recipient's Name and TIN

List the designated beneficiary as the recipient only if
the distribution is made (a) directly to the designated
beneficiary, or (b) to an eligible educational institution for the
benefit of the designated beneficiary. Otherwise, list the
account owner as the recipient of the distribution. Enter the
TIN for the applicable recipient."

So, the way the 1099-Q is populated seems to align with these other websites in terms of who's responsible for the taxes.

I agree with pirsquared, I wonder if the IRS Pub 970 was making an assumption.

 

[cathy63]

This just seems so counter intuitive to always report the taxes on the beneficiary's tax return for non-qualified distributions that went to the owner/parent, especially when the beneficiary doesn't even receive the tax form.

So, I could leave the money in the 529 for another 10-20 years, and then make some withdrawals, pocket the money (with gains), and then my son gets to pay the taxes and extra 10% on the gains. What's not to like?

And what if the beneficiary predeceases the account owner and is no longer filing taxes at all? You can change the beneficiary on a 529, so theoretically you could pick an older relative who's close to death and just wait for the inevitable before emptying the account tax free. I'm pretty sure that wouldn't actually work and the IRS would have some questions for you if nobody reports the income.

In fact, when the IRS sent us a letter about a different error a few years ago, they "helpfully" included all of our 529 withdrawal in our income and assumed it was 100% taxable (none of it was). They didn't even ask the student about it, just assigned the income to the parents.

 

[SecondCor521]

This could be a problem as then DD would be required to file a return, right? Currently, she is not required to file a return which means her summer job income did not need to be included in our income for ACA purposes,

Possibly. It would depend on if your DD's income hit any of the thresholds in Chart B (or, less commonly, any of the situations in Chart C) in "Who Must File?" in the instructions for Form 1040. For my kids, that was usually around $12,000 of income, but the rules in Chart B depend on the mix of earned and unearned income.

As for the other replies in this thread, I think I've changed my mind again.

To me, the hierarchy of authority goes:

Constitution
--> Law
----> IRS Publications
------> Popular websites

Out of curiosity, I went and looked up section 529 in the law, and it is surprisingly readable. In relevant part, it seems to say that they money is includable in gross income of the distributee. (Which is the point in the law cited by one of the popular websites listed above by @RetiredAt55.5.)

That makes sense, for all the reasons everyone above has pointed out.

It seems that Pub 970 isn't clear enough on this point and may be making assumptions. I find this disappointing.

@RetiredAt55.5, regarding the instructions for Form 1099-Q, yes, I read that. But that's just telling the 529 custodian how to complete the form; it doesn't say anything about whose taxable income it might be. Also, if it is always taxed to the distributee (as the websites say and the actual law also seems to say), then I don't understand why the IRS would have box 6 on there.

 

[pirsquared]

Possibly. It would depend on if your DD's income hit any of the thresholds in Chart B (or, less commonly, any of the situations in Chart C) in "Who Must File?" in the instructions for Form 1040. For my kids, that was usually around $12,000 of income, but the rules in Chart B depend on the mix of earned and unearned income.

I realized that this will be a non-issue for 2021 since DH had unemployment income and thus our household income is capped for ACA purposes. I did go in to the ACA website and update our income to reflect my planned non-qualified withdrawal. I put it under my name and not DD's but that won't matter in the end as it is based on household income.

DD's income would still not reach $12,000, but it would exceed the $1100 of unearned income that is a trigger point for filing.

 

[SecondCor521]

I realized that this will be a non-issue for 2021 since DH had unemployment income and thus our household income is capped for ACA purposes. I did go in to the ACA website and update our income to reflect my planned non-qualified withdrawal. I put it under my name and not DD's but that won't matter in the end as it is based on household income.

One thing to note for planning purposes is that the unemployment feature of the ACA PTC is only in place for 2021 (as of now, pending further legislation).

 

[pirsquared]

One thing to note for planning purposes is that the unemployment feature of the ACA PTC is only in place for 2021 (as of now, pending further legislation).

Yes, thanks for the reminder. DH is no longer drawing unemployment anyway. He decided to retire last spring. At the point that he decided he would no longer seek work, he stopped certifying for unemployment. Both the UI itself and the ACA subsidy increase were incredibly helpful, though, as he had originally planned to work several more years (his company had mass layoffs due to covid).