Calculating Tax on Unqualified 529 Withdrawal

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psy1
Posts: 67
Joined: Thu Jan 31, 2019 1:40 am

Calculating Tax on Unqualified 529 Withdrawal

Post by psy1 » Tue Jul 16, 2019 2:53 am

I am trying to see if I understand the taxation of an unqualified withdrawal from 529 plan in the case of an "overfunded" plan, realizing that I could leave the money in the plan for future generations.

My understanding is that I have the option to direct the withdrawal to my child who would owe the tax. In this case, say the 529 has 80% contributions and 20% earnings.

If my child is still in college, has no income, and files taxes independently as a single person he would have a standard deduction of $12,200 and owe 10% federal tax on the first $9,700 of income (i.e. the unqualified withdrawal). Therefore the federal income tax rate on the first $21,900 is ~4.4%.

Suppose that in 2020, while still in college, the student took a $100,000 unqualified withdrawal (in addition to qualified withdrawals). That means the ~$20,000 in earnings would be taxable and subject to the 10% penalty. The resulting federal tax would be approximately $20,000 X 0.044 = $880 + $2000 in penalties. That is an effective tax rate of 14.4% plus it liberates a lot of money from the 529 which seems like a compelling deal to me.

Are my assumptions and arithmetic correct?

Spirit Rider
Posts: 10989
Joined: Fri Mar 02, 2007 2:39 pm

Re: Calculating Tax on Unqualified 529 Withdrawal

Post by Spirit Rider » Tue Jul 16, 2019 5:47 am

Your assumptions and results would only be correct if they were no longer college students or >= age 24. Non-qualified 529 distributions to a college student < age 24 are unearned ordinary income subject to the Kiddie Tax.

They would have an unearned standard deduction up to $1100*, the next $1100 would be subject to the dependent's 10% ordinary income tax rate and the next $2600 would be subject to the trust 10% ordinary income tax rate. Amounts above that would be subject to 22%+ ordinary income tax rates in compressed trust brackets.

*The first $750 in earned income reduces the unearned income standard deduction dollar for dollar down to $350. The remaining $350 is reduced dollar for dollar to $0, when earned income exceeds $12,200 - $350. In all cases, the dollar for dollar reduction increases the amount taxed at the dependent's 10% ordinary income tax rate.

Topic Author
psy1
Posts: 67
Joined: Thu Jan 31, 2019 1:40 am

Re: Calculating Tax on Unqualified 529 Withdrawal

Post by psy1 » Tue Jul 16, 2019 6:46 am

Understood, thank you. I forgot ab out the kiddie tax.

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