689 / Are certain distributions from a qualified tuition program (529 Plan) taxable?

In the case of excess cash distributions, the amount otherwise includable in gross income must be reduced by a proportion that is equal to the ratio of expenses to distributions.² In-kind distributions are not includable in gross income so long as they provide a benefit to the distributee which, if paid for by the distributee, would constitute payment of a qualified higher education expense.³

Nonqualified distributions (i.e., distributions that are not used to pay “qualified higher education expenses”) are includable in gross income. However, the amount of the distribution representing the amount paid or contributed to the 529 plan are not taxable. An individual receiving a distribution from a 529 plan will receive a Form 1099-Q. The gross distribution received is entered in Box 1 of the form. That amount will be divided between the earnings generated from the 529 plan (Box 2) and the basis (return of investment) (Box 3). Consider the following example based on the example in IRS Publication 970:

Example: In 2013, Asher’s parents opened a 529 plan. Over a number of years, they contributed $18,000 to the plan. Ten years later, the balance in the plan was $27,000. At that time, Asher enrolled in college and paid $8,300 of qualified education expenses for the rest of the year. Those expenses were paid from the following sources:

Gifts from parents	$1,600
Partial scholarship (tax-free)	$3,100
529 Plan distribution	$5,300

Step 1 – Determine the “adjusted qualified education expenses.” Adjusted qualified education expenses (AQEE) are the amount of qualified education expenses ($8,300) less tax-free educational assistance ($3,100). Therefore, AQEE is $5,200 ($8,300 minus $3,100).

Thus, the 529 plan distribution of $8,300 exceeds Asher’s AQEE of $5,200. For that reason, a portion of the distribution will be taxable. According to Asher’s Form 1099-Q, Box 2, $950 of the distribution is earnings.

Step 2 – Compute the tax-free earnings. Multiply the total distributed earnings ($950) by a fraction, the numerator of which is AQEE ($5,200) and the denominator of which is the 529 plan distribution ($5,300), or:

$950 (total earnings ×	$5,200 (AQEE)	= $932 (tax-free earnings)
	$5,300 (distribution)

Step 3 – Compute the taxable earnings. Subtract tax-free earnings ($932) from total earnings ($950), or $950 minus $932, which equals taxable earnings of $18 that must be included in gross income.

Additionally, there is a 10 percent additional tax imposed on nonqualified distributions in the same manner as is imposed on certain distributions from Coverdell Education Savings Accounts (see Q 683).⁴ The 10 percent additional tax does not apply if the payment or distribution is
(1) made to a beneficiary on or after the death of the designated beneficiary, or (2) attributable to the disability of the designated beneficiary.⁵

Repeal of the Aggregation Requirement

For distributions made after December 31, 2014, the Protecting Americans from Tax Hikes Act of 2015 (PATH) eliminated the requirement that, in calculating the earnings portion of any distribution that exceeds qualified education expenses, all Section 529 plans of which an individual is a designated beneficiary will be treated as one program. Forms 1099-Q must generally be furnished to distributees on or before January 31 of the year following the year of a distribution, and to the IRS on or before February 28, or, if filing electronically, March 31. Because of the difficulties involved in adjusting 529 plan systems to comply with the retroactive repeal of the aggregation requirement, the IRS provided transition relief. The IRS did not impose penalties for inaccurately reported earnings on 2015 Forms 1099-Q that were solely due to the repeal of the aggregation requirement.

Guidance Provided in Notice 2001-81

In Notice 2001-81, the IRS announced that final regulations would provide that only those accounts maintained by a qualified tuition program and having the same account owner and the same designated beneficiary must be aggregated in the computation of the earnings portion of any distribution.⁶ The notice also indicated that the final regulations would revise the time for determining the earnings portion of any distribution from a qualified tuition account. Specifically, for distributions made after 2002, such programs are required to determine the earnings portion of each distribution as of the date of the distribution. A different effective date applies to direct transfers between qualified tuition programs.⁷ Finally, the notice states that with respect to any distributions made after 2001, a qualified tuition program will no longer be required to verify how distributions are used or to collect any penalty. However, the program must continue to verify whether the distribution is used for qualified higher education expenses of the beneficiary.⁸