Many states allow their residents to participate in a 529 plan, also known as a qualified tuition plan, to either set money aside for their chosen beneficiary's educational expenses or to prepay tuition. The IRS, as well as the state in which you create the 529 plan, allows the funds you contribute to the plan to grow tax-free. However, the tax reporting implications of the distributions vary depending on how the beneficiary uses the funds.
1099-Q Distribution Reporting
Once you establish your 529 plan and designate a beneficiary, the institution that manages the plan has an obligation to report every distribution on IRS Form 1099-Q. The form reports the gross distribution made to the beneficiary in Box 1. However, Box 2 reports the amount of the distribution that represents earnings and Box 3 reports the original contribution. For example, suppose you make a one-time contribution to a 529 plan of $30,000, which earns $10,000 of tax-free interest prior to the beneficiary taking a distribution. If the distribution amount is $10,000, the 1099-Q will report that amount in Box 1, $2,500 in Box 2 and $7,500 in Box 3.
If the beneficiary's "adjusted qualified higher education expenses" for the year are at least $10,000, the beneficiary receives the entire distribution tax-free. This means that the student can pay their school expenses without having to include any part of the distribution in their gross income when preparing a tax return. However, when a distribution from a 529 plan exceeds adjusted qualified higher education expenses, some of it may be taxable to the student-beneficiary.
Qualified Education Expenses
In order to determine the tax consequences of the 529 plan distribution, it's necessary for the beneficiary to calculate their education expenses for the year. This includes the cost of tuition and fees, the expense of purchasing books, supplies and equipment for their courses plus reasonable charges for room and board if the beneficiary enrolls at least half-time. However, to determine what the adjusted expenses are, the beneficiary must reduce their total educational expenses by any additional tax-free assistance they receive in the form of a scholarship, Pell grant, employer reimbursement or benefits from a veterans' organization.
Calculating Taxable Distribution
Although a beneficiary must report the distribution on a tax return if it exceeds their adjusted qualified higher education expenses, they will not pay tax on the entire distribution. The student only reports the earnings that the 1099-Q reports in Box 2. This is because the initial contributions that the account owner makes to the 529 plan come from after-tax earnings. Only the income that the initial contributions earn is subject to tax. Additionally, the IRS can impose a 10-percent penalty on the taxable portion of the distribution, but there are concessions for students who receive scholarships and other forms of educational assistance.
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