529 Plan: Higher Education, Learning the Hard Way

Suppose you have tried to be a good parent and saved diligently into a 529 plan so your kid could pay for college. The big day has arrived and you laughed off that tuition bill because you had plenty of 529 plan money and were able to pay it off. Two years have gone by and you can no longer remember what it was like to have a kid in the house when you get a CP 2000 notice from the IRS. Surprise, the IRS just sent you a proposed bill for $5,000 plus $1,000 penalty & interest for your 529 plan distribution. So what happened? The IRS had a surprise bill of their own. Let’s examine what just happened here.

529 Plan: Great Way to Save for College

A 529 plan can be a great way to save for college. While getting money into the plan can be straight forward, getting money out can trigger the IRS to request additional documentation. The reason is often that the parent takes the 529 distribution right into their own bank account and then write out a check to the college themselves. Don’t do it!

Should I deposit the distribution to my bank account or write a check directly to the college?

When the 529 plan reports the distribution to the IRS, they are required to report it under the Social Security number of the parent. The IRS computers scan your tax for 529 plan income. These computers automatically generate a proposal to tax (and penalize) you for the distribution. Why? Because the computer is blind to any college expense. In one sense, the computer is correct, the parent did not have any tuition expense, their child did. The Form 1098-T reporting the tuition to the IRS is reported under the Social Security number of the child. And yes, the IRS computers cannot put 2 and 2 together on this one.

Where do I report the 529 Plan information on my tax return?

In order to exacerbate the issue, there is no form or schedule to report this on your tax return. There is a worksheet to compute whether any 529 distributions are taxable but when you file your return, the IRS does not take worksheets into account. In my opinion, the creation of a form or schedule would easily remedy the vast majority of these cases but I’m not holding my breath.

What is the 529 Plan solution?

The existing solution is to have the 529 plan make payments directly to the college or university. In this case, the Form 1098-T AND Form 1099-Q both show up under the student’s Social Security number and the two figures annihilate each other like an electron and a positron. (Yes, I know a little bit about science).

Do 529 Plan payments always work?

This sounds great in theory but it is not always feasible for a number of reasons. Form 1098-T only reports tuition but not other qualified education expenses such as fees or room & board. A parent can have more than one child in college at a time and would have to change the designated beneficiary on the 529 plan every time they need to make a distribution. The school’s bursar’s office may also treat the distribution as scholarship money which can create other tax issues.

What are other problems with 529 distributions?

Other problems include failing to coordinate 529 distributions with other family member. Taking a distribution in the wrong year such as taking money out in December but not paying the expenses until January. Taking out too much money can also cause you to become ineligible for the American Opportunity or Lifetime Learning Credit.

Do you intend to pay for college expenses with a distribution from a 529 plan?

If you do intend to pay for college expenses with a 529 Plan distribution, it helps to plan ahead. If you have any questions, please feel free to call Alex Franch, BS EA at our Worthtax office at 781.849.7200, he’ll be glad to help. Worthtax has locations in Quincy, Weymouth and Dedham. One final note, the IRS revamped Form 1098-T for 2017; hopefully this will help us all out in the future.