Distributions (Tuition Program)
Distributions from a Sec 529 plan follow the Code Sec. 72 annuity rules meaning that distributions are treated as representing a pro-rata share of the principal (i.e., contributions) and accumulated earnings in the account. So, the part of the distribution representing the amount paid or contributed to the QTP doesn't have to be included in income, because that part is a return of the investment in the plan.
Computation of Earnings
Under prior law for purposes of applying section 72, all Sec 529 qualified tuition programs of which an individual was a designated beneficiary were treated as one program. The PATH Act eliminated the aggregation requirement for distributions after December 31, 2014.
Taxable Earnings if Excess Distributions
If the distribution exceeds the “adjusted qualified education expenses” – qualified education expenses reduced by any tax-free scholarships or fellowships, VA education assistance, Pell grants, and similar nontaxable payments – information on Form 1099-Q will be used to determine what portion of the earnings may be taxable. If the distribution is totally nontaxable, no reporting of the distribution is required on the recipient’s income tax return. Any taxable amount is included on the “other income” line of the recipient’s Form 1040, Schedule 1, line 8z (2024).
Who pays the tax on a nonqualified distribution? When a nonqualified distribution is taken from a Sec 529 plan it is taxable to the recipient of the distribution. Distributions from a 529 plan may be paid directly to the educational institution, to the beneficiary or to the account owner. Here is where it gets messy. It is taxable to whoever’s name is on the distribution check. For example, a grandmother who is the account owner cannot take the distribution and then assign the income to the granddaughter who is the student-beneficiary. IRC Sec 529(c)(3)(A) says nonqualified distributions are to be included in the gross income of the distributee.
Of course, only the earnings included in a nonqualified distribution are taxable and the taxable earnings are subject to a 10% penalty.
Example: Over several years Naomi’s parents had contributed $18,000 to a qualified tuition plan they set up that is administered by their state government. During the tax year, Naomi enrolled in college and had $6,700 of qualified education expenses; some of the expenses were offset by a $3,100 tax-free scholarship. The $3,600 balance was paid from a $3,700 withdrawal from the QTP, which had a balance of $27,000 when the distribution was made. Form 1099-Q issued to Naomi shows $1,200 of the distribution is earnings. Since the amount of the distribution exceeds the adjusted qualified education expenses Naomi had, $32 of the earnings included in the distribution is taxable, which Naomi will report on her 1040, Schedule 1, line 8z, if she’s required to file a return.
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Total qualified education expenses 6,700
Less scholarship <3,100>
Adjusted qualified education expenses. 3,600
1,200 x 3,600/3,700 = 1,168 (nontaxable part of earnings)
1,200 – 1,168 = 32 (taxable part of earnings)
Refunds & Recontribution of Funds
What happens when Sec 529 qualified tuition program funds are distributed for a beneficiary's qualified higher education expenses, but some portion of those expenses subsequently is refunded to the beneficiary, for example, when the beneficiary drops a class mid-semester? The portion of a distribution refunded to a Sec 529 beneficiary is not subject to income tax to the extent that, within 60 days of the date of the refund, it is recontributed to a Sec 529 qualified tuition program of which the individual is a beneficiary.