Tax code squishy on 529 plan withdrawal

By: Savingforcollege.com

Q:

Dear Joe, Does a scholarship withdrawal from a 529 college savings plan need to be taken in the same year as the scholarship is awarded, or can that withdrawal (with the 10 percent penalty waived) be elected anytime? According to your site, a scholarship withdrawal is a nonqualified distribution requested after the beneficiary receives a tax-free scholarship. For federal purposes, the earnings portion of the distribution is taxable, although the usual 10 percent penalty is waived. -- Jeff

A:

Dear Jeff,

I wish I could give you a 100 percent certain answer to your tax question, but unfortunately I cannot. As so often happens, the tax code is not entirely clear and the Internal Revenue Service has not provided much help to taxpayers in interpreting the law.

It makes perfect sense that if the 529 account beneficiary receives a scholarship, the usual 10 percent federal tax penalty on nonqualified distributions from 529 plans is waived to the extent of that scholarship.

After all, you should not be penalized for having more money in a 529 plan than needed for college expenses when scholarships have caused the situation.

Section 530(d)(4) of the Internal Revenue Code says the penalty exception applies to distributions "made on account of" a scholarship.

My own opinion is that you should able to look back to prior years for scholarships whenever you make a nonqualified distribution. In many cases, you may not be able to determine until after the final semester of school if you'll have money leftover in your 529 plan.

Unfortunately, my opinion is not necessarily going to hold up if the IRS audits your tax return. You and your tax professional are ultimately responsible for any position you take on your tax return.

In Publication 970, the IRS describes the penalty exception in a slightly different way: The penalty does not apply to distributions "included in income because the beneficiary received" a scholarship.

The differences between the tax code and IRS Publication 970 may seem insignificant, but suggest to me that the IRS might want to see the distribution made in the same year as the scholarship.

In the past, I found that scholarship distributions from a 529 plan often worked out very nicely. The earnings portion of the distribution could be reported to the student at zero or low tax cost, and without penalty.

But in 2008 and future years, the "kiddie tax" is expanded to include most full-time college students, thus causing the earnings portion of the 529 distribution in many cases to be taxed at the parents' tax rate.