529 plan distributions added back to the state

[Mike12321]

If qualified education expenses are used for the AOC, then do distributions from a 529 plan become taxable on the state? I understand there is no double dipping, but the funds were still used to pay qualified education expenses.

[Terry53029]

If you pay all expenses with the 529, then you can't take the credit

[Maxine · Accepted solution]

Are there room & board charges?  Fees that do not qualify for the AOTC?  The 529 can be used for those expenses.  If still not enough, to cover the 529 withdrawal.  The program splits figures the % of interest not used and that becomes taxable to the owner of the account.  Then if a state  deduction was taken in previous years, the % of principal not used has to be reclaimed on the state.  But principal is never taxable at the federal level, only earnings.  I do this all the time to come up with max expense for the AOTC.

[Mike12321]

Coordination With American Opportunity and Lifetime Learning Credits An American opportunity or lifetime learning credit (education credit) can be claimed in the same year the beneficiary takes a tax-free distribution from a QTP, as long as the same expenses aren't used for both benefits. This means that after the beneficiary reduces qualified education expenses by tax-free educational assistance, he or she must further reduce them by the expenses taken into account in determining the credit. Example 2. Assume the same facts as in Example 1, except that Sara's parents claimed an American opportunity credit of $2,500 (based on $4,000 expenses). Total qualified education expenses $8,300 Minus: Tax-free educational assistance − 3,100 Minus: Expenses taken into account in figuring American opportunity credit − 4,000 Equals: Adjusted qualified education expenses (AQEE) $1,200 The taxable part of the distribution is figured as follows. 1. $950 (earnings) × $1,200 AQEE   $5,300 distribution = $215 (tax-free earnings) 2. $950 (earnings) − $215 (tax-free earnings) = $735 (taxable earnings)
Sara must include $735 in income (Schedule 1 (Form 1040 or 1040-SR), line 8). This represents distributed Chapter 8 Qualified Tuition Program (QTP)  Page 59
earnings not used for adjusted qualified education expen

[Mike12321]

Thanks, Maxine

That was the answer I was looking for. I had put the distribution on the state as an addition, but wasn't sure. I think maximizing the AOC is worth the cost of paying a little extra tax on the distribution earnings on the Fed and the total distrib on the state. For the student in my case, her income is so low, very little if any was taxable.

I was also confused about where to enter the info about eliminating the 10% penalty, but it looks to me like that is input on the 5329 smart box, ie amounts used for credits etc.

Thanks!

[rbynaker]

I think you have a good handle on the federal.  I haven't run across the state issue (I advise my clients to pay $4K/yr. from non-529 plan funds just so we don't have to deal with allocations).

I was curious so I looked at the code of VA as an example (and something I'm familiar with).  It just references IRC 529 for the definition of "qualified higher education expenses" (qhee).

https://law.lis.virginia.gov/vacode/title58.1/chapter3/section58.1-322.03/

That takes us to IRC "Section" 529, "Sub-section" (e), "Paragraph" (3)--and yes, I'm deliberately being verbose here since words matter:

https://www.law.cornell.edu/uscode/text/26/529#e_3

The section of IRC that causes some qhee to be taxable income at the federal level is "Section" 529, "Sub-section" (c), "Paragraph" (3).

Note in "Sub-paragraph" (B):

"For purposes of this paragraph" [referring to 529(c)(3), not 529(e)(3)]

"Clause" (v):

"The total amount of qualified higher education expenses with respect to an individual for the taxable year shall be reduced . . ."

So this tells you how to determine taxable income, not what constitutes a qhee.  That definition is in a different paragraph.  Had Congress wanted to modify the definition of qhee, they could have done so in Sub-section (e).  They didn't do this, they just modified how you calculate what's included in gross income in Sub-section (c) and specifically limited this modification to one paragraph of tax code.

I'm not curious enough to research court cases but to me, in VA, this suggests that you don't have to recapture the VA deduction if the distributions were used to pay expenses that were federally allocated to AOTC/LLC.

Others may disagree with me, and they may be right.  I would research it further before signing a return.  I think it's worth looking at your state tax code to see what definitions they're using and under what conditions you have to recapture the deduction.  I'm guessing they're not all going to be the same.

Rick

[Maxine]

You made my hurt a little on that lol.  In Iowa there is an other income line specifically to recapture 529 distributions that were not used for education expenses.  I have a feeling that since Iowa taxes everything they can get their hands on there would be no exceptions.  Will try to check it out more later in the year.  Thanks for the insight.

[rbynaker]

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@Maxine wrote:

You made my hurt a little on that lol.  In Iowa there is an other income line specifically to recapture 529 distributions that were not used for education expenses.  I have a feeling that since Iowa taxes everything they can get their hands on there would be no exceptions.  Will try to check it out more later in the year.  Thanks for the insight.

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Oh good, I'm a big guy so I was able to absorb most of the damage.  Made my head hurt a LOT!  Glad to hear yours only hurt a little!

Rick