Recently we have seen audit activity by the IRS focusing on redemptions from 529 college savings plans. This is a bit surprising given the fact that 529 plans are relatively new. The IRS is unlikely to find large investment gains built up in these vehicles nor are any penalties for non-qualified withdrawals likely to be a huge windfall for them. Nonetheless, nobody likes to get mail from the IRS, especially if you are unprepared. What do you need to do to be ready?
Investments in 529 plans grow tax deferred. When withdrawals are taken, details are reported to the IRS via form 1099-Q. The withdrawals may be paid to the account owner, the beneficiary, or the college/university. Each withdrawal is made up of a pro rata share of original contribution (basis) and investment gains (if any). There are, however, no taxes calculated or withheld. The entire withdrawal remains tax free provided it is used for the account beneficiary’s “Qualified Education Expenses.” Generally this includes tuition, room and board, mandatory fees, and books. Other rules and limitations, however, apply. Thus it is a good idea to talk through a strategy with a Certified Financial Planner or your tax advisor.
The investment gain portion of any withdrawal that is not used for qualifying expenses is subject to income tax and possibly a 10% penalty. This is what the IRS is reviewing. Reporting the applicable taxes and penalties is the responsibility of the account owner or beneficiary. So you can see, keeping good records is the key. Tuition invoices should be filed together with withdrawal confirmations and the current year’s 1099-Q. Or better yet, consider having withdrawals paid directly to the college or university to keep things in good order.
It’s also necessary to coordinate withdrawals with other tax breaks and scholarships. The American Opportunity Credit, Lifetime Learning Credit, and Student Loan Interest Deductions may be available to you but you can’t double dip: You cannot claim one of these benefits for the same expense that was paid with 529 proceeds. Further the IRS waives the penalty for withdrawals equal to the amount of scholarships. Therefore don’t forget about any awards earned by your student.