529 withdrawal question

Does a 529 withdrawal have to be in the same year that the qualified education expense was paid?

I withdrew funds last August to pay for first semester college expenses for my child. Then, in late December I made another withdrawal to pay for second semester college expenses.

For the first withdrawal, the withdrawal and payment of college expenses were both in calendar year 2006. For the second withdrawal, the withdrawal was in late 2006, but the expense was paid in January 2007.

When I figure my 2006 taxes will there be a penalty on the second withdrawal because the funds were withdrawn in 2006, but expenses were paid in 2007?

tessie, you will have tax and a penalty on the second withdrawal, to the extent of the "growth" portion of the withdrawal. Since you made contributions with after-tax money, only the amount of your withdrawal that represents growth will be taxed and penalized.

For example, let's say you made contributions of $10,000 to the account. This grew over time to $15,000. So for every $1,500 that you distribute from the account, $500 is taxable (or not, if used for qualified education expenses), and $1,000 is return of your contributions. To keep things simple, let's say that your second withdrawal in December was for $1,500. You will owe ordinary income tax on $500, plus there is a 10% penalty against that $500 since it was not used (in the current year) for qualified education expenses. Keep in mind that, even though the first $1,000 is effectively a return of your contributions, your qualified education expenses must use the distribution in ratio - in other words, you couldn't pay $500 worth of education expenses and say that it was the growth portion that you used. It has to be used in proportion to the overall withdrawal.

Hope this helps -

I had a similar question with regard to the timing of 529 withdrawal. I am more confused now. I thought it's ok to withdraw money earlier, say in 2006, and pay for qualified education expenses later, say in 2007. You just had less tax-free gain for the period when money sitting outside 529.

I just made payment for my son's summer class (qualified education expenses). I believe I have to request a withdrawal this year. I plan to do it this December so I can have money grow tax-free for seven more months. Am I right?

60563 - unless I'm mistaken (which has happened before, although rarely!), your qualified expenses and distributions from 529 plans are netted on a tax year basis, so if there are excess distributions in the tax year (versus qualified expenses), there will be tax and penalty on the growth portion of the excess distributions.

You are correct that you can take the distribution later in the same tax year for expenses earlier in the year, but not for future years' expenses. You will receive a 1099-Q for the distribution from the 529 plan, and a 1099-T for the qualified tuition and fee expenses to take you through the calculations.

I didn't know you can not take the distribution for future years' expenses. Thanks.

The following is from IRS Announcement 2008-17

"Accordingly, the IRS and the Treasury Department propose to adopt a rule that, in order for earnings to be excluded from income, any distribution from a section 529 account during a calendar year must be used to pay QHEEs during the same calendar year or by March 31 of the following year. The IRS and the Treasury Department welcome comments on rules necessary to ensure that distributions from section 529 accounts are appropriately matched to the payment of QHEEs"

This will solve the problem of the calendar year used for tax purposes and a fiscal year used for the academic calendar.

robwiles57, you are correct, for tax years 2008 forward, the rule is different from when the original question was asked. As of the ruling in 2008, you have until 3/31 of the following year to pay expenses (QHEE) and then net the amounts (expenses vs. distributions) in order to determine taxability.

So your title is not correct ("probably not taxable") as the time stamps make it completely clear that we were discussing a 2007 tax question, and given that timeframe, the activity in question "probably was taxable". Might want to update that to say "probably not taxable for 2008 and beyond".

Thanks for updating the information though, for future reference.