2

My understanding is that early (nonqualified) withdrawals from a 529 plan are penalized at 10%, plus taxed over any capital gains.

Does the 10% penalty apply to capital/investment gains only, or to the cost basis (original contributions) as well?

If the 10% penalty is only imposed on capital gains, how is it determined whether the money pulled out is from the original contributions or from gains?

0

Since you asked about the 10% Federal penalty and taxable portion my answer is about that. Mhoran’s answer points out additional state tax implications.

The short answer is that the penalty is on the earnings portion only.

And the short answer for how much of the distribution is from earnings is that it comes from the amounts the 529 plan provider reports on form 1099Q.

The longer answer is that Publication 970 describes how to calculate a taxable distribution based on the amount a distribution is more than qualified education expenses and take into account various exceptions. It also states that

Generally, if you receive a taxable distribution, you also must pay a 10% additional tax on the amount included in income.

The really long answer for how the earnings portion of a distribution is determined (ie what the plan provider puts on form 1099Q) is given in two references that the instructions to form 1099Q only list and link to:

Box 2. Earnings To determine the earnings or (loss) on the gross distribution reported in box 1, use the earnings ratio described in Proposed Regulations section 1.529-3, Notice 2001-81, and Notice 2016-13. You can find Notice 2001-81 on page 617 of Internal Revenue Bulletin 2001-52 at IRS.gov/pub/irs-irbs/ irb01-52.pdf and Notice 2016-13 at IRS.gov/irb/ 2016-07_IRB/ar06.html.

Basically the revenue bulletin and notice describe the timing of account values to use to make a ratio of the earnings portion of the account to the total value of the account. And that ratio is used to determine the amount of earnings to allocate to that distribution.

  • I see, so it's not cut and dry - part of the distribution can be marked as coming from capital gains, and the rest from the original contributions? – Phillip Apr 25 at 3:27
  • 1
    @Phillip Yes that’s what the provider does when sending the 1099Q – T. M. Apr 25 at 10:34
0

While the Federal penalties may be limited to the earnings portion of the non-qualified withdraw, there is also the state tax implications for states that give a tax break for contributions:

For example from the Virginia529 website:

Is is possible to Cancel my Account:

Yes. Accounts can be cancelled at any time. Keep in mind that earnings that are not used for qualified higher education expenses are subject to a 10 percent federal tax penalty (with certain exceptions for death, disability and scholarships), plus federal and state income taxes on the earnings reportable on the taxpayer’s return, and the recapture of any Virginia tax deduction previously taken on the amount of the cancellation or refund.

Here is a site that compares provisions of 529 plans with some other examples:

California:

There is no state tax deduction and therefore no recapture. However, a non-qualified withdrawal by a California taxpayer is subject to an additional 2.5% California penalty tax on the earnings portion, but only if subject to the the additional 10% federal additional penalty tax.

Indiana :

An account owner must pay with the Indiana tax return a tax equal to the lesser of 20 percent of a nonqualified withdrawal from this plan, or the excess of (a) the total amount of all Indiana state income tax credits claimed by any contributor to the account for all taxable years beginning on or after January 1, 2007 over (b) the total amount of any repayments made for all taxable years beginning on or after January 1, 2008. Nonqualified withdrawals for this purpose include rollovers but do not include withdrawals made as the result of the beneficiary's death or disability or withdrawals made on account of the beneficiary's receipt of a scholarship. Recapture will apply to any account terminated within 12 months from account opening date.

For fun read the one for Minnesota.

  • Luckily, I'm in a no-state-tax state – Phillip Apr 25 at 14:59

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service, privacy policy and cookie policy

Not the answer you're looking for? Browse other questions tagged or ask your own question.