Non-qualified 529 distributions due to scholarships

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ElwoodBlues
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Non-qualified 529 distributions due to scholarships

Post by ElwoodBlues » Wed Nov 07, 2018 10:54 am

Can anyone explain or point me to a good reference that explains the mechanics of making a non-qualified 529 distribution under the scholarship exception? I understand that scholarships relieve you from the 10% penalty, and that you pay tax on the earnings portion, but I still have 2 questions:

1. Does all of this still have to align with the calendar year? In other words, the non-qualified portion of the distributions needs to not exceed the amount of scholarships awarded in this year? (I believe this to be the case, but the vast majority of 529 info online is focused on the basics and not the actual mechanics of dealing with significant scholarship impact to an adequately funded 529.)

2. How does this work in conjunction with qualified distributions? Is the max withdrawal for a year simply the qualified expenses plus the total scholarship (non-qualified) amount? And then pay income tax on the earnings portion of the non-qualified portion?

[Deleted my original post, and reposting here, as I think I posted in the wrong area initially.]

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UpsetRaptor
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Re: Non-qualified 529 distributions due to scholarships

Post by UpsetRaptor » Wed Nov 07, 2018 11:06 am

Yes it's calendar year. So if you have a scholarship for $40K total across four school years, the amount of non-penalty non-qualified distributions available is, year by year, $5k-$10K-$10K-$10K-$5K, because of the semester overlap. If that makes sense.

ElwoodBlues
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Re: Non-qualified 529 distributions due to scholarships

Post by ElwoodBlues » Wed Nov 07, 2018 12:04 pm

UpsetRaptor wrote:
Wed Nov 07, 2018 11:06 am
Yes it's calendar year. So if you have a scholarship for $40K total across four school years, the amount of non-penalty non-qualified distributions available is, year by year, $5k-$10K-$10K-$10K-$5K, because of the semester overlap. If that makes sense.
It makes sense. Making my brain shift gears back and forth between semesters and tax year was quite a struggle to begin with.

Actually, in our case it's a slightly different mix. Most of the scholarships for spring semester actually hit in the previous December. Only a small amount pays in January. It's more like $9K, $10K, $10K, $1K.

Regardless, I think I have accidentally mismanaged this with the oldest kid. We did not make scholarship withdrawals during bachelors degree, thinking we would need the money for grad school when all of the scholarships would end. Then, he was awarded a graduate assistanceship, and grad school is essentially a free ride (free tuition + monthly stipend that is enough to cover everything else).

Will not make the same error with siblings, but will still be tricky to balance.

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HueyLD
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Re: Non-qualified 529 distributions due to scholarships

Post by HueyLD » Wed Nov 07, 2018 12:42 pm

I looked all over the map, including 26 U.S. Code § 529 - Qualified tuition programs, IRS Pub 970, IRS FAQs and so forth. But I could not find anything that says that 529 distributions must be done in the same year of scholarships in order to receive a waiver of the 10% penalty.

It is obviously easier if they match. But in the absence of a clear guidance, I would take the position that 529 distributions after the year of scholarship is entitled to the 10% penalty waiver. I would provide an attached statement to the tax return describing the situation.

But if you would change the beneficiary to another qualified family member, it would be better.

ElwoodBlues
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Re: Non-qualified 529 distributions due to scholarships

Post by ElwoodBlues » Wed Nov 07, 2018 1:48 pm

HueyLD wrote:
Wed Nov 07, 2018 12:42 pm
I looked all over the map, including 26 U.S. Code § 529 - Qualified tuition programs, IRS Pub 970, IRS FAQs and so forth. But I could not find anything that says that 529 distributions must be done in the same year of scholarships in order to receive a waiver of the 10% penalty.

It is obviously easier if they match. But in the absence of a clear guidance, I would take the position that 529 distributions after the year of scholarship is entitled to the 10% penalty waiver. I would provide an attached statement to the tax return describing the situation.

But if you would change the beneficiary to another qualified family member, it would be better.
Not sure how attaching a statement would work. Everything is filed electronically, and I thought most of it is analyzed by computer, at least initially, isn't it? Is there some special IRS form for basically saying "Hey IRS, here is why my return looks odd"? (Seriously, is there something like that?)

Changing beneficiary might help some, but kid 2 is essentially in same situation, so there is probably not enough scholarship amount to cover withdrawing roughly 3/4 of each kid's savings. I haven't done the exact math yet, pending finding some answers to my original question #2.

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HueyLD
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Re: Non-qualified 529 distributions due to scholarships

Post by HueyLD » Wed Nov 07, 2018 2:13 pm

You can certainly attach a statement electronically to your tax return that you e file. Lots of people do just that every year.

There is no maximum limit on the amount that you can withdraw from a 529 plan. However, if you withdraw more than QHEE, there will be tax consequences. Keep in mind that the QHEE definition is different for every tax favored instruments.

There are a lot of examples in IRS publication 970. Check it out.

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UpsetRaptor
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Re: Non-qualified 529 distributions due to scholarships

Post by UpsetRaptor » Wed Nov 07, 2018 3:01 pm

HueyLD wrote:
Wed Nov 07, 2018 12:42 pm
I looked all over the map, including 26 U.S. Code § 529 - Qualified tuition programs, IRS Pub 970, IRS FAQs and so forth. But I could not find anything that says that 529 distributions must be done in the same year of scholarships in order to receive a waiver of the 10% penalty.

It is obviously easier if they match. But in the absence of a clear guidance, I would take the position that 529 distributions after the year of scholarship is entitled to the 10% penalty waiver. I would provide an attached statement to the tax return describing the situation.

But if you would change the beneficiary to another qualified family member, it would be better.
On another 529 thread some time ago where this question came up, someone said that they were audited, for something non-529 related, but in the process the IRS was clearly matching up 529 penalty-free distributions for scholarships to the year the scholarship $ applied to the tuition/education expenses, not in bulk the initial year the full scholarship was awarded. So that's where I got that, even though I know it's anecdotal.

It does make sense though. I know some people who were awarded a full scholarship but ended up losing it after a year or two for not keeping a high enough GPA. If the full scholarship was a penalty-free 529 distribution in full that first year, that'd be...well either a loophole where they got away with one, or a big mess to go back and fix later. That situation can apply to scholarship-turned-dropouts too.

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unclescrooge
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Re: Non-qualified 529 distributions due to scholarships

Post by unclescrooge » Wed Nov 07, 2018 3:06 pm

UpsetRaptor wrote:
Wed Nov 07, 2018 11:06 am
Yes it's calendar year. So if you have a scholarship for $40K total across four school years, the amount of non-penalty non-qualified distributions available is, year by year, $5k-$10K-$10K-$10K-$5K, because of the semester overlap. If that makes sense.
Does the first $5k have to be withdrawn in the same tax year as the first semester? Or, like an HSA, can it be withdrawn anytime after the fact?

Spirit Rider
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Re: Non-qualified 529 distributions due to scholarships

Post by Spirit Rider » Wed Nov 07, 2018 3:08 pm

You are correct that 26 Section 529 is silent on the issue of whether qualified distributions, penalty-free distributions and qualified educational expenses must occur in the same tax year. This is compounded by the fact that the 1998 proposed 529 regulations or those suggested would come from IRS Notice Announcement 2008-17 Advance Notice of Proposed Rulemaking for 529 plans were NOT published in the Federal Register as final regulations. There are in fact still no 529 regulations.

The IRS acknowledged as much when in the latter they stated;

"Section 529 is silent regarding whether distributions must be made from a section 529 account in the same tax year as QHEEs were paid or incurred. Concerns have been raised that individuals could allow the account to grow indefinitely on a tax-deferred basis before requesting reimbursement or use distributions in earlier years to pay QHEEs in later years. Accordingly, the IRS and the Treasury Department propose to adopt a rule that, in order for earnings to be excluded from income, any distribution from a section 529 account during a calendar year must be used to pay QHEEs during the same calendar year or by March 31 of the following year. The IRS and the Treasury Department welcome comments on rules necessary to ensure that distributions from section 529 accounts are appropriately matched to the payment of QHEEs."

However, IRS Publication 970 Tax Benefits for Education, Chapter 8. Qualified Tuition Program (QTP), page 51, Figuring the Taxable Portion of a Distribution states;

"To determine if total distributions for the year are more or less than the amount of qualified education expenses, you must compare the total of all QTP distributions for the tax year to the adjusted qualified education expenses."

And, IRS Publication 970 Tax Benefits for Education, Chapter 8. Qualified Tuition Program (QTP), page 53, Additional Tax on Taxable Distributions

"Generally, if you receive a taxable distribution, you also must pay a 10% additional tax on the amount included in income."

If the determination of a taxable income must be based on a tax year reconciliation of all QTP distributions to the adjusted qualified education expenses, then it clearly follows that the 10% additional tax is assessed for that tax year.

However, here is where it gets interesting. Federal Tax Law Hierarchy is as follows:
  • U.S. Constitution (Congressional power to enact tax laws)
  • Internal Revenue Code (IRC) (Foundation for all federal tax authority)
  • U.S. Treasury Regulations
    • Final
    • Temporary
    • Proposed
  • IRS Positions
    • Revenue Rulings
    • Revenue Procedures
    • Notices and Announcements
    • Private Letter Rulings, Determination Letters, Technical Advice Memoranda, and Chief
      Counsel Advice. Are all guidance on a specific taxpayer’s situation. While they can not be relied on as substantial authority, they give the IRS' thinking on specific circumstances.
    • IRS Forms, Publications, and FAQs are informational only for taxpayer assistance and do not provide any substantial authority.
From the many CP-2000 notices that people have received (including two of my own). The IRS is clearly taking the position espoused in Pub 970 by matching the 1099-Q with the 1099-T for a given tax year. Note: That in both cases it was incorrect assumptions on their part not me crossing years.

Here is the big dilemma. The IRS appears to take the default position that taxable income must be based on a tax year reconciliation of all QTP distributions to the adjusted qualified education expenses of that year. If you were to dispute their substantial authority to do so, it is quite likely that you will get a CP-2000 notice from the IRS. Whether you could prevail in your response to the IRS, who knows. Personally, I would not take that chance.

Soon2BXProgrammer
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Re: Non-qualified 529 distributions due to scholarships

Post by Soon2BXProgrammer » Wed Nov 07, 2018 3:19 pm

Spirit Rider wrote:
Wed Nov 07, 2018 3:08 pm
Here is the big dilemma. The IRS appears to take the default position that taxable income must be based on a tax year reconciliation of all QTP distributions to the adjusted qualified education expenses of that year.
Summary: So the safe bet is to do everything based on the calendar year? Either withdrawals to match expenses or reimbursements for scholarships, etc?

Spirit Rider
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Re: Non-qualified 529 distributions due to scholarships

Post by Spirit Rider » Wed Nov 07, 2018 3:22 pm

Soon2BXProgrammer wrote:
Wed Nov 07, 2018 3:19 pm
Spirit Rider wrote:
Wed Nov 07, 2018 3:08 pm
Here is the big dilemma. The IRS appears to take the default position that taxable income must be based on a tax year reconciliation of all QTP distributions to the adjusted qualified education expenses of that year.
Summary: So the safe bet is to do everything based on the calendar year? Either withdrawals to match expenses or reimbursements for scholarships, etc?
Correct, that is the universal view.

Iorek
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Re: Non-qualified 529 distributions due to scholarships

Post by Iorek » Wed Nov 07, 2018 6:01 pm

Does this whole discussion assume that the scholarship is being awarded by the school (e.g., "merit aid") and therefore lowers QHEE?

If you get a scholarship from say, Rotary, then presumably it would not lower QHEE and you could withdraw the full amount of tuition from the 529 tax-free, right?

Spirit Rider
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Re: Non-qualified 529 distributions due to scholarships

Post by Spirit Rider » Wed Nov 07, 2018 6:46 pm

Iorek wrote:
Wed Nov 07, 2018 6:01 pm
Does this whole discussion assume that the scholarship is being awarded by the school (e.g., "merit aid") and therefore lowers QHEE?

If you get a scholarship from say, Rotary, then presumably it would not lower QHEE and you could withdraw the full amount of tuition from the 529 tax-free, right?
The source of the scholarship is irrelevant. The only thing that matters is its tax status. A scholarship or fellowship grant is tax free only to the extent:
  • It doesn't exceed your qualified education expenses;
  • It isn't designated or earmarked for other purposes (such as room and board), and doesn't require (by its terms) that it can't be used for qualified education expenses; and
  • It doesn't represent payment for teaching, research, or other services required as a condition for receiving the scholarship. Exceptions exist for certain payment for services.
If the scholarship is not tax-free, it must be included in income and it would not lower your QHEE.

ElwoodBlues
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Re: Non-qualified 529 distributions due to scholarships

Post by ElwoodBlues » Thu Nov 08, 2018 9:42 am

OP here,

So to firm up my understanding of question 2, can anyone confirm the following examples are correct?

Example 1 (withdraw max scholarship amount):
Qualified Education Expenses: 18,000
Scholarships: 12,000
AQEE: 18K-12K = 6,000
529 Distributions: 6,000 (qualified) & 12,000 (non-qualified)
Tax: 10% of earnings on non-qualified, so 12,000 * (529 Earnings/529 Total) * 10% = 12,000 * (15,000/30,000) * 10% = 600
Additional Tax: None (scholarship exception)

Example 2 (exceed max scholarship amount):
Qualified Education Expenses: 18,000
Scholarships: 12,000
AQEE: 18K-12K = 6,000
529 Distributions: 6,000 (qualified) & 15,000 (non-qualified)
Tax: 10% of earnings on non-qualified, so 15,000 * (529 Earnings/529 Total) * 10% = 15,000 * (15,000/30,000) * 10% = 750
Additional Tax: additional 10% of earnings of non-qualified distribution above scholarship amount?
= 3,000 * (529 Earnings/529 Total) * 10% = 3,000 * (15,000/30,000) * 10% = 150
Total Tax = 900

Am I looking at this correctly?

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UpsetRaptor
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Re: Non-qualified 529 distributions due to scholarships

Post by UpsetRaptor » Thu Nov 08, 2018 12:56 pm

No, you do not pay the 10% tax on the scholarship amount of $12K, you pay the income tax on the earnings for it but no penalty.

ElwoodBlues
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Re: Non-qualified 529 distributions due to scholarships

Post by ElwoodBlues » Thu Nov 08, 2018 9:01 pm

UpsetRaptor wrote:
Thu Nov 08, 2018 12:56 pm
No, you do not pay the 10% tax on the scholarship amount of $12K, you pay the income tax on the earnings for it but no penalty.
Sorry, I think that's what I was trying to say, but I probably crammed it all together.

Example 1 Tax:
10% of earnings on non-qualified, so 12,000 * (529 Earnings/529 Total) * 10% = 12,000 * (15,000/30,000) * 10% = 600

meaning of the 12,000, you'd pay 10% on the earnings portion of that, which in this example was the ratio of the total earnings of the account (15,000) divided by the total value of the account (30,000).

so 1/2 of 12,000 would be the taxable earnings (6,000), multiplied times the 10% tax rate to end up with $600 final tax amount.

Right? :?:

Spirit Rider
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Re: Non-qualified 529 distributions due to scholarships

Post by Spirit Rider » Thu Nov 08, 2018 9:47 pm

I not sure where you got the 10% income tax rate and if it is correct. Note: Income tax liability is assessed to whoever receives the non-qualified distribution.

If the beneficiary receives the distribution, it is taxable at their marginal rate.

If the account owner receives the distribution, it is taxable at their marginal rate.

ElwoodBlues
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Re: Non-qualified 529 distributions due to scholarships

Post by ElwoodBlues » Thu Nov 08, 2018 10:14 pm

Spirit Rider wrote:
Thu Nov 08, 2018 9:47 pm
I not sure where you got the 10% income tax rate and if it is correct. Note: Income tax liability is assessed to whoever receives the non-qualified distribution.

If the beneficiary receives the distribution, it is taxable at their marginal rate.

If the account owner receives the distribution, it is taxable at their marginal rate.
:oops: Ok, makes sense now. I think I had even thought through that before, knowing that the kids rate would be lower than mine. I think in reading IRS Pub 970 too much, I somehow brainwashed myself into reading phrases like "subject to the 10% additional tax" as "subject to an additional 10% tax".

So aside from the fictitious tax rate in both, is Example 2 correct as far as the 10% additional tax only applying to the portion of the non-qualified distribution that is over and above the scholarship amount?

Thanks to everyone providing answers and input on this, as it's been really helpful for filling in the gaps in the IRS documents. :beer

ElwoodBlues
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Re: Non-qualified 529 distributions due to scholarships

Post by ElwoodBlues » Thu Nov 08, 2018 10:32 pm

Ok, I believe I see it now, between Publication 970 and Form 5329 and it's instructions.

5 Distributions included in income from a Coverdell ESA, a QTP, or an ABLE account
6 Distributions included on line 5 that are not subject to the additional tax (see instructions)
7 Amount subject to additional tax. Subtract line 6 from line 5
8 Additional tax. Enter 10% (0.10) of line 7. Include this amount on Form 1040, line 59, or Form 1040NR, line 57

So for Example 2 is it like this?:
5: 15,000
6: 12,000
7: 3,000
8: 300

Or is this again only supposed to be on the earnings portion of some of these numbers?

ElwoodBlues
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Re: Non-qualified 529 distributions due to scholarships

Post by ElwoodBlues » Thu Nov 08, 2018 10:49 pm

Ok, one more try, incorporating info from https://www.savingforcollege.com/intro- ... d-529-plan
"Only the earnings portion of a non-qualified withdrawal is subject to a 10% withdrawal penalty"

5 Distributions included in income from a Coverdell ESA, a QTP, or an ABLE account
6 Distributions included on line 5 that are not subject to the additional tax (see instructions)
7 Amount subject to additional tax. Subtract line 6 from line 5
8 Additional tax. Enter 10% (0.10) of line 7. Include this amount on Form 1040, line 59, or Form 1040NR, line 57

So then:
5: 7,500 (50% of the 15,000 total distribution; assuming account is 50% contribution / 50% earnings in these examples)
6: 6,000 (50% of the 12,000 scholarship excepted withdrawal amount)
7: 1,500
8: 150

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