Question on Excess Contribution and Distributions to 529

[jeffs1]

I contributed $200,000 to a 529 account in 2023. I recently filed form 709 for a contribution that exceeds the gift tax exclusion amount of $17,000. I will not pay any gift tax on the overage amount ($183,000) as I am applying this to the lifetime gift exclusion amount of $12.2 million dollars. The 529 has earned 5% and will be worth $210,000 in a few months. I would like to take a distribution for the entire amount and close the 529 account (going to invest in something else). It is my understanding that I can take a distribution for the account balance $210,000. It will be reported on form 1099-Q that $200,000 will be the basis (principle) and $10,000 will be the earnings. The basis is not subject to penalty or tax as it is already taxed dollars. The $10,000 earnings will be used for a qualified tuition payment for my daughter who is the beneficiary on this 529. Does anyone know if all this sounds ok or if I am violating any rules here? Please let me know if I need to clarify anything or provide additional info. Thank you.

[Mark_Kantrowitz_SFC]

529 plans are not like a Roth IRA where you can split principal and earnings. Everything is proportional.

By withdrawing the full $210,000 you will be taking a $10,000 qualified distribution and a $200,000 non-qualified distribution.

Of the $10,000 distribution, $476 will be earnings and $9,524 will be principal.

Of the $200,000 distribution, $9,524 will be earnings and $190,476 will be principal. The $9,524 will be subject to ordinary income tax at the recipient's rate, plus a 10% tax penalty. So, assuming you are in the 24% tax bracket, you will pay $3,238 in federal income tax. In addition, there will be state income tax on the $9,524, plus recapture of any state income tax breaks attributable to the distribution.

[jeffs1]

Mark, thank you very much for your response. I have had a difficult time finding a local tax specialist who was confident in answering this question. No state income tax in TN, so I assume everything you said above is accurate and disregard the mention of paying any state tax?
A couple other questions:
I am the account owner and my daughter is the beneficiary. If I take the full $210,000, is the check made out to myself or to the beneficiary, or does it matter?
Is there another option here I am overlooking where I can avoid tax/penalties?
Jeff

[Mark_Kantrowitz_SFC]

Tax preparers are not familiar with 529 plans and are often nervous about answering questions concerning them.

If your state does not have an income tax, then it does not have state income tax breaks on 529 plan contributions. Only about two-thirds of the states have such state income tax breaks.

You can choose whether to have the check made payable to the account owner or the beneficiary. This mainly matters for non-qualified distributions, since the earnings portion of a non-qualified distribution is taxed at the recipient's rate. Generally, beneficiaries often have a lower tax bracket than account owners, so it can be beneficiary to have it paid to them. But, then, the distribution is legally the property of the beneficiary, so you wouldn't be able to spend it yourself.

Normally I'd say to consider a rollover to a Roth IRA, which lets you take a return of contributions, but you'd need to be invested in the 529 plan for 15 years to take advantage of this, and the rollovers are limited to an aggregate maximum of $35,000.

Otherwise, there aren't loopholes for avoiding tax/penalties.

[jeffs1]

Good info again - this is a great help.

I will get the check made payable to myself (account owner). Currently the account balance is at $206,000. It won't reach $210,000 for a few more months. From a tax/penalty perspective I think it makes sense for me to take the full distribution sooner than later. Less penalty/taxes on the non-qualified earnings distribution.