Uh-oh...did I just make a 529 withdrawal tax blunder?

[LMK5]

My daughter is the beneficiary of a 529 plan. The plan owner is an irrevocable trust in which I'm the trustee. I received a bill from the college in December 2016 for the 2017 spring semester. I made a withdrawal (to the account owner) in late December, but I didn't pay the school until January 6, 2017. I called the school and they said that the 1098-T should show the amounts for both the fall 2016 and the spring 2017 tuition.

1) Will the fact that the 1098-T shows both 2016 (fall) and 2017 (spring) charges be at all helpful in avoiding taxes/penalties for non-qualified withdrawals?
2) Is there any way to get out of the tax penalty that will result from me paying in 2017 while making the withdrawal in December 2016?
3) For a trust which has to file a 1041 each year, is there a way to take advantage of any federal education tax credits? Is it more advantageous for me, as an individual, to own the 529 instead of the trust?

Thanks for the help!

[dcandmc]

1) In my experience, 1098-Ts are mostly worthless. You really need to go by when the expenses were actually paid. That's what matters for matching up 529 distributions and the expenses they are meant to cover.

2) Maybe you can reverse the 529 distribution and then redo it in 2017? Brian hopefully has a better answer.

3) Generally, the parent of a student who is claimed as a dependent on the parent's tax return can claim tax credits for the student's qualified education expenses, even if those expenses were paid by someone else (such as a trust, in your case). Just remember that expenses paid with 529 funds cannot also be used to claim tax credits.

[LMK5]

Thanks for the response dcandmc. It sounds like the1098-Ts are not reliable, but does the IRS consider them when comparing what was paid to what was billed? What else would the IRS go by to verify that the college actually billed the student/parent?

In the case of question 3), if the expenses were paid from a 529 plan that the trust owns, can the parent of the student still claim some kind of education credit? Do you know which IRS publication talks about how parents can claim a credit even when someone else pays the dependent's education expenses?

[dcandmc]

For 529 distribution to expense payment matching, it doesn't matter when the expense was billed. The IRS doesn't care what was billed or when it was billed. They want to know that 529 distributions are matched to qualifying education expenses paid in the same calendar year.

In the case of question 3), if the expenses were paid from a 529 plan that the trust owns, can the parent of the student still claim some kind of education credit?

Yes, as long as there are qualified education expenses that haven't already been paid using tax-advantaged funds (like from a 529, or a non-taxable grant or scholarship). If the Trust has paid all of the student's qualified education expenses using 529 money, there won't be anything left over that can be claimed using one of the educational tax credits.

Do you know which IRS publication talks about how parents can claim a credit even when someone else pays the dependent's education expenses?

See IRS pub 970, the note near the top of the right column on page 10 under "Who Can Claim the Credit?" in the American Opportunity Credit section:

https://www.irs.gov/pub/irs-pdf/p970.pdf

(The linked pub is for tax year 2015, but there shouldn't be any change for tax year 2016.)

[LMK5]

Thanks for the great info. In the case of the trust paying the educational expenses, if the money comes from the trust and not from the trust-owned 529 plan, can the parent claim an education credit for the dependent student?

[dcandmc]

For a parent to claim an education tax credit for a tax-dependent student, it doesn't matter who pays the student's educational expenses, as long as the payment isn't from tax-advantaged funds.

From IRS pub 970:

"Qualified education expenses paid... by a third party for [your] dependent, are considered paid by you."

[LMK5]

Wow, I'm surprised. Doesn't this bring into question whether 529 plans are advantageous at all? Are there any analyses which show whether one is better off without the 529 plan so they can take the credit? Off the bat, it seems to me that if expenses are paid out of a 529 fund with no cumulative gains, the parent is actually losing out because there is no tax savings and of course no credits can be taken, whereas if they didn't have the 529 plan they could take the credits.

[dcandmc]

You can still use education tax credits while taking advantage of a 529 account; you just have to make sure that you're not using the same qualified education expenses for more than one tax benefit.

The American Opportunity Credit and the Lifetime Learning Credit are the two educational tax credits. Of the two, the AOC is generally the better credit, assuming that the taxpayer is fully eligible for both credits. The AOC provides a credit of up to $2,500 (up to $1,000 is refundable) on up to $4,000 in qualified education expenses. So if you have a 529 account and also want to use the AOC, pay $4,000 of AOC eligible expenses with non-529 dollars. For example:

Let's say that for the fall semester for a full-time student, tuition is $20,000, fees are $500, room and board is $5,000, and required books/supplies are $500, for a total of $26,000. All of these are 529 eligible expenses. But instead of paying the full $26,000 from the 529, pay only $22,000 from the 529, and pay the other $4,000 from a regular checking or savings account (anything that's not using tax-advantaged dollars). You can designate this $4,000 as going to pay part of the tuition bill, since tuition is an AOC eligible expense. This way, you can use 529 funds to pay most of the expenses, and still take full advantage of the AOC.

IRS pub 970 has advice for coordinating between 529 accounts and the tax credits. See page 61 of the previously linked document.

[Brian_Boswell_SFC]

2) Is there any way to get out of the tax penalty that will result from me paying in 2017 while making the withdrawal in December 2016?

There may be tax consequences resulting from taking a withdrawal for an expense you did not incur during the same tax year. There aren't a lot of options for you should the IRS challenge you on the withdrawal. You do have 60 days from the date of the withdrawal to make a full or partial rollover of those funds to another 529 plan without tax or penalty. So to be safe you could open a 529 plan in another state, deposit the funds, then turn around and make a withdrawal for the expense you incurred.

It's a lot of paperwork to get you to the same place, and it's always possible the IRS won't even challenge you on the withdrawal. But, based on the information given, turning the withdrawal into a rollover then making a corresponding qualified withdrawal would be a the most conservative approach to avoid potential taxes and penalties.

I think @dcandmc hit all your other questions, but happy to help if anything was missed.

Thank you,

Brian Boswell
VP, Research & Development

This information does not constitute tax advice and is provided for informational purposes only. Please consult your tax advisor, financial advisor, local taxing authority, and/or plan provider or sponsor for more information.

[LMK5]

Mr. Boswell and dcandmc, thanks for your additional replies. I have three 529 accounts with Vanguard, one for each child. I called Vanguard this morning and they said I could do an "indirect rollover" within 60 days. They said that I could take the money that I withdrew in late December and I can send them a check for the amount to be deposited into one of the sisters' 529 accounts.

Does this sound proper? If so, will I be able to show on the trust tax return that even though an extra 15k was withdrawn from the account, that I performed a rollover within the 60 day period? Is there a mechanism for this on the trust tax return and if so, will it nullify the 15k withdrawal? Any pitfalls here?

Another option: Having paid the school on January 6, is there any stipulation that allows me to claim that the funds were paid in 2016, or is the calendar year crossing cemented in stone?

[dcandmc]

If so, will I be able to show on the trust tax return that even though an extra 15k was withdrawn from the account, that I performed a rollover within the 60 day period? Is there a mechanism for this on the trust tax return and if so, will it nullify the 15k withdrawal?

Let's start with the basics: is the $15k withdrawal that you want to rollover a taxable event? If so, taxable to whom? If it's not a taxable event, than nothing should appear on any tax return. If it is a taxable event, but not for the trust, than nothing will appear on the trust's tax return (although this means that someone else's return will have to reflect the event).

Having paid the school on January 6, is there any stipulation that allows me to claim that the funds were paid in 2016, or is the calendar year crossing cemented in stone?

I think you're pretty much stuck with the January 6 payment date.

[LMK5]

dcandmc, since the 15k withdrawal was paid to the owner (the trust), then the money (earnings) would be taxable to the trust since the money got transferred out in 2016, but not paid to the school until January 2017. If I am correct, can an indirect rollover into the sister's Vanguard 529 account be performed in the amount of 15k, effectively nullifying the 15k withdrawal for 2016? Is this easily performed on the 2016 tax return due in April?

[dcandmc]

Sorry, I am not well informed on 529 rollovers and tax implications. I would think that if you redeposit the amount previously withdrawn ($15k) using a rollover, that effectively nullifies the $15k 529 payment to the school and therefore earnings that are part of that payment are no longer a concern. Hopefully Brian can impart some wisdom.

[Brian_Boswell_SFC]

Is this easily performed on the 2016 tax return due in April?

A rollover does not have to be reported, you just have to make sure the receiving 529 plan knows it is a rollover and receives the tax basis information from the old 529 plan so that it can keep track of the basis going forward. So you do not have to report it on your tax return.

Good luck,

Brian Boswell
VP, Research & Development

This information does not constitute tax advice and is provided for informational purposes only. Please consult your tax advisor, financial advisor, local taxing authority, and/or plan provider or sponsor for more information.

[LMK5]

Thanks Brian. But if I don't report the 15k rollover in some fashion on the tax return, then how do I escape the tax hit due to the 15k withdrawal? From what Vanguard said, they still must report the December 2016 15k withdrawal on the 1099-Q in spite of the rollover. How do I justify not paying the tax on the return if I don't report the rollover in some way?

[Brian_Boswell_SFC]

From what Vanguard said, they still must report the December 2016 15k withdrawal on the 1099-Q in spite of the rollover. How do I justify not paying the tax on the return if I don't report the rollover in some way?

That's right- the plan will report the distribution, but it will also report the rollover, so it'll all balance out. You'll still receive a 1099-Q, but you don't have to report anything on your federal income tax return since you made the rollover (assuming you make the rollover, at least!).

Brian Boswell
VP, Research & Development

This information does not constitute tax advice and is provided for informational purposes only. Please consult your tax advisor, financial advisor, local taxing authority, and/or plan provider or sponsor for more information.

[LMK5]

Thank you Brian. I think that's my best course of action: get with Vanguard and roll the withdrawn amount into her sister's plan. As you mentioned, Vanguard will report the 15k withdrawal on the 2016 1099-Q. Since my rollover will occur in January 2017, do you know how, and on what form, Vanguard will report the rollover to me so that I have some kind of official record of the rollover?