Are 529 Plans Really Tax-free

Financial Professional Content I got a worried message from Terry Savage a couple weeks ago. Savage is a nationally known expert on personal finance, the markets and the economy. She relayed a story to me two friends; a college advisor and a CPA. It went something like this: The CPA is recounting that their client recently made a qualified withdrawal on their 529 savings account, closing out the account. Much to the surprise of the client, the CPA informs him that a pro-rata tax will be assigned to the gains. The CPA provides reams of backup documentation, taken from IRS documents to this effect, with detailed notes and highlights backing up their claim, showing that all withdrawals are assigned a pro rata earnings portion. So, is the CPA correct? Yes- sort of. Section 529 of the internal revenue code is vague in places, and specific in others. It is well-documented by the original legislation, the IRS, and the SEC that, "no tax is due on a distribution from a QTP unless the amount distributed is greater than the beneficiary's adjusted qualified education expenses." (IRS Publication 970). So where is the confusion? So here it is: All distributions include both a principal and a pro rata earnings portion, and the account owner will receive a 1099-Q from the plan to this effect. "Pro rata" means in proportion, so every withdrawal would include a portion of earnings. But none of it is taxable unless the withdrawal is non-qualified. This seems to be where our experts became confused and, fair enough, it's complicated language buried in documentation going back to the EGTRRA (Economic Growth and Tax Relief Reconciliation Act of 2001). Consider, for example, IRS Notice 2001-81. This document was drafted in 2001 to provide clarity on the EGTRRA, and in the first paragraph explicitly states, "This notice provides guidance regarding certain recordkeeping, reporting, and other requirements applicable to qualified tuition programs described in S529 of the Internal Revenue Code..." This document is for the plan providers and recordkeepers. The second paragraph of the main document reiterates that qualified withdrawals are tax-free. It also details how plan providers should account for distributions on a pro-rata basis. However, the account owner does not owe tax on qualified withdrawals just because the withdrawal contains an earnings portion. IRS Notice 2001-81 tells plan providers how they are required to report withdrawals on their forms. So the IRS says, "Hey, tell your clients that this portion is principal and this other portion is earnings. They don't need to actually pay the tax if the withdrawal was qualified, but we make sure all your "i's" are dotted and "t's" are crossed." There are examples given in Publication 970 that outline this very thing. Then why have all this complicated language around "pro rata" distributions if none of it is taxed? These accounts were created to help people save and pay for college, and to prevent their abuse or using them as tax shelters the government penalizes withdrawals made for other purposes. So, if the account owner takes a non-qualified withdrawal, that earnings portion will be taxed AND penalized. The pro rata language ensures a penalty is always assessed for non-qualified withdrawals. Itï ¿ ½s easy to see where even professionals could be confused by the code. All distributions are allocated between principal and earnings on a pro-rata basis. But rest assured, none of the distribution is taxable so long as it is a qualified withdrawal. This is basically an accounting exercise, and does not change the fact that distributions are completely tax-free when used for qualified higher education expenses. RELATED: The best way to withdraw 529 funds Financial Professional Content I got a worried message from Terry Savage a couple weeks ago. Savage is a nationally known expert on personal finance, the markets and the economy. She relayed a story to me two friends; a college advisor and a CPA. It went something like this: The CPA is recounting that their client recently made a qualified withdrawal on their 529 savings account, closing out the account. Much to the surprise of the client, the CPA informs him that a pro-rata tax will be assigned to the gains. The CPA provides reams of backup documentation, taken from IRS documents to this effect, with detailed notes and highlights backing up their claim, showing that all withdrawals are assigned a pro rata earnings portion. So, is the CPA correct? Yes- sort of. Section 529 of the internal revenue code is vague in places, and specific in others. It is well-documented by the original legislation, the IRS, and the SEC that, "no tax is due on a distribution from a QTP unless the amount distributed is greater than the beneficiary's adjusted qualified education expenses." (IRS Publication 970). So where is the confusion? So here it is: All distributions include both a principal and a pro rata earnings portion, and the account owner will receive a 1099-Q from the plan to this effect. "Pro rata" means in proportion, so every withdrawal would include a portion of earnings. But none of it is taxable unless the withdrawal is non-qualified. This seems to be where our experts became confused and, fair enough, it's complicated language buried in documentation going back to the EGTRRA (Economic Growth and Tax Relief Reconciliation Act of 2001). Consider, for example, IRS Notice 2001-81. This document was drafted in 2001 to provide clarity on the EGTRRA, and in the first paragraph explicitly states, "This notice provides guidance regarding certain recordkeeping, reporting, and other requirements applicable to qualified tuition programs described in S529 of the Internal Revenue Code..." This document is for the plan providers and recordkeepers. The second paragraph of the main document reiterates that qualified withdrawals are tax-free. It also details how plan providers should account for distributions on a pro-rata basis. However, the account owner does not owe tax on qualified withdrawals just because the withdrawal contains an earnings portion. IRS Notice 2001-81 tells plan providers how they are required to report withdrawals on their forms. So the IRS says, "Hey, tell your clients that this portion is principal and this other portion is earnings. They don't need to actually pay the tax if the withdrawal was qualified, but we make sure all your "i's" are dotted and "t's" are crossed." There are examples given in Publication 970 that outline this very thing. Then why have all this complicated language around "pro rata" distributions if none of it is taxed? These accounts were created to help people save and pay for college, and to prevent their abuse or using them as tax shelters the government penalizes withdrawals made for other purposes. So, if the account owner takes a non-qualified withdrawal, that earnings portion will be taxed AND penalized. The pro rata language ensures a penalty is always assessed for non-qualified withdrawals. Itï ¿ ½s easy to see where even professionals could be confused by the code. All distributions are allocated between principal and earnings on a pro-rata basis. But rest assured, none of the distribution is taxable so long as it is a qualified withdrawal. This is basically an accounting exercise, and does not change the fact that distributions are completely tax-free when used for qualified higher education expenses. RELATED: The best way to withdraw 529 funds