Question about nonqualified 529 withdrawal

[SecondCor521]

Hi all.

I have three children - DS25, DS20, and DD18 - each of whom has their own 529 accounts.

I made a nonqualified withdrawal from DD18's 529 account on 3/10/2020 for an expense for DD18. The expense definitely was not a QHEE.

I am aware that NQ withdrawals generally result in taxable income in the year of the withdrawal according to some calculations in Pub 970.

DD18 has other taxable income, mostly the result of scholarships in excess of her college costs. (Yes, I'm quite proud of them.)

Because DD18 will be my dependent in 2020, it is possible that their other taxable income plus the income from the aforementioned NQ withdrawal will result in DD18 being required to file a tax return for 2020.

If DD18 has to file a tax return in 2020, then their income needs to be added to my Form 8962, and that addition will decrease our ACA subsidy.

I'm not sure it's possible, but I'd like to avoid that.

In retrospect, I could have transferred the money from DD18's 529 to one of their brothers' 529s, then made the NQ withdrawal from his account. It would have added to his taxable income, of course, but since my sons are not my dependents in 2020, it would not have been added to my Form 8962.

Since I am outside the 60-day recontribution window, I think the answer is probably no, but I'm wondering if there are any creative ways to retroactively make this NQ withdrawal from their account be from one of their brother's accounts or otherwise avoid having the income added to my ACA MAGI.

...

Also, if anyone cares, I do things that affect my children's tax returns if the result of doing so is beneficial in the long term to us. I have a policy that I will compensate them for anything that I do of this nature which increases their tax liability. So in this example if I were able to shift a DD18 NQ withdrawal to one of my sons, I would pay that son for whatever the increase in their tax bill was.

 

[cathy63]

Who did the 529 custodian send the money to, you or DD18? Whichever one of you received the distribution should be the one to get a 1099-Q next year, and that person is the one responsible for reporting the distribution on their tax return. If it's all going to end up on your return anyway, it probably doesn't make much difference which of you gets the 1099, but if there's a chance that your DD might not have to file, it's better if it goes to her. Also, the return of contributions isn't taxable, it's only the earnings that are subject to tax and the 10% penalty.

This might also be of some interest: https://www.investopedia.com/news/penaltyfree-way-get-529-money-back/

The scholarship exception, however, lets you withdraw up to the amount of that scholarship and use the money for any purpose penalty free. The earnings on that portion of the distribution will still be subject to income tax.

I don't see any way to make the money come from another child's account at this point. Even if you swap two accounts by changing the beneficiary names, the custodian should still send a 1099 for the withdrawal to the original beneficiary (or you as the owner). You do still have 4 months left in 2020, so could you drum up some additional qualified expenses, even if they are for things that aren't really needed until next year? A new computer maybe?

 

[njhowie]

How much money are we talking about here and what was the non-qualified expense for? Is DD in college now or still in high school?

Key thing to remember when it comes to 529 funds, similar to taxes in general, it's pretty much honor system. Unless the amount withdrawn would raise red flags, the very high likelihood is that nothing would come of it.

Are there not any qualified expenses that you could claim the funds for? Move expenses around? Pay some of fall expenses out of pocket and claim the earlier withdrawal was for the later qualified expenses still in 2020?

Also, keep in mind that in the event you do go the route of paying taxes on the withdrawal, taxes are only due on the investment gains, not the contribution amounts.

 

[SecondCor521]

Thanks for the replies.

In response to the questions/suggestions:

@cathy63:

The money was sent to me, but I know from experience that the 1099-Q will be sent with DD18's SSN on it and the taxable portion should be reported on her return.

Yes, I understand that only a portion of it is taxable. That's why I referenced the calculations in Pub 970.

I'm familiar with the scholarship exception. DD18 qualifies for that in spades, so there won't be the 10% penalty, just the taxable income per the calcs in Pub 970.

The suggestion to drum up qualified expenses is a good one, but may be difficult. DD18 already has scholarships in excess of their entire cost of college, and already bought a new computer earlier this year. I'll comb through and see what I can find, though.

@njhowie:

The withdrawal was about $2K, and was for the program fee to participate in a competitive drum and bugle corps program that they wanted to do this past spring (they're a music kid). They agreed that we could raid the college fund for that expense.

DD18 graduated from high school this spring and started college this fall (this week in fact).

I understand it's an honor system, but I try to file taxes accurately as much as I can.

As noted above, all of DD18's qualified expenses have been more than covered by scholarships. In fact, they're expecting to receive a several thousand dollar refund from the university (which I think is also taxable, but that's a different story).

I'll investigate the notion of paying some of the fall expenses out of pocket (which I might do anyway to get the AOTC).

And right, I understand that taxes are only due on a portion of the withdrawal according to the calculations in Pub 970. (I left it out to simplify, but I've made both qualified and non-qualified withdrawals this year from their 529. I'm comfortable making those calculations.)