Inheriting a 529

By Mark Kennan

A 529 plan is a savings plan that offers tax benefits to a person saving for future higher education costs, including college, trade school or a graduate program. You can have either a 529 college savings plan or a 529 prepaid tuition plan. With a savings plan, you put money into an account and invest it so you can use it for college costs in the future. With a prepaid tuition plan, you purchase credits from a state college at the price in effect when you purchased the plan. However, if the beneficiary goes to a different school, you might not get your full value back. You may also inherit a 529 plan from a relative, with monies left to you for the express purpose of funding your education.

Taxes on Distributions

If you take a qualified distribution from a 529 plan, you don't pay taxes on the money or report the distribution on your income tax return. Qualified distributions are those used for certain higher education expenses, known as qualified expenses. If you don't use the money withdrawn from your inherited 529 plan for qualified expenses, you are taking what is known as a "non-qualified distribution." The earnings portion of this distribution is taxable. For example, imagine your inherited 529 plan has $100,000 in it -- $70,000 of which was contributed by the decedent and $30,000 from investment returns. If you take a $10,000 distribution, $7,000 is counted as contributions and $3,000 is regarded as earnings. If you use the money for anything besides qualified higher education expenses, you would have to include the $3,000 as part of your taxable income for the year.

Qualified Expenses

Qualified expenses are the costs of attending a post-secondary school, such as a trade school, college or graduate program. These always include your tuition and mandatory fees. For example, a technology fee that every student must pay would qualify because it is a mandatory fee imposed on every student who wants to attend the school. However, a fee to participate in a club sport or intramural would not qualify, because participating in a club sport or intramural is not a required cost of attending the school. If you enroll at least half-time in school, you can also include the cost of room and board as a qualified expense. For example, if your school considers 15 credit hours to be full-time, you must enroll in at least 7.5 credit hours to count your room and board costs as qualified expenses.

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Penalties Waived

Typically, non-qualified distributions from 529 plans incur an additional 10 percent penalty on plan earnings. However, when you inherit a 529 plan after the death of the person who was supposed to benefit from the plan, you are technically receiving the distributions as the beneficiary of the decedent. For example, if you inherit a 529 plan that named your sister as the designated beneficiary, you don't have to pay the 10 percent additional tax. However, this exception does not allow you to escape the income taxes on the plan's earnings. For example, assume you take a $10,000 non-qualified distribution composed of $7,000 in contributions and $3,000 in earnings. The penalty exception allows you to avoid the 10 percent penalty, but not income taxes on the $3,000.

Coordination with Other Benefits

Be aware that you cannot double count educational expenses for 529 plan distributions and an education tax credit or deduction, such as the American Opportunity Tax Credit, Lifetime Learning Credit or Tuition and Fees Deduction. The American Opportunity Credit offers a tax credit up to $2,500 for expenses paid in the first four years of post-secondary education. The Lifetime Learning Credit offers a tax credit up to $2,000 for any post-secondary educational costs. For example, if you have $5,000 in qualified expenses and use $4,000 of it to claim the American Opportunity Credit, you only have $1,000 in qualified educational expenses remaining to take as a distribution from your 529 plan. In addition, you must reduce your qualified expenses by any tax-free assistance you receive, such as scholarships. For example, if you have $10,000 in qualified expenses but receive a $7,000 scholarship, you may only take a $3,000 tax-free distribution from your 529 plan.

Fixing Excess Withdrawals

If you realize you have taken out more than you should have, you can put it back within 60 days without a problem. For example, assume you expected to have $20,000 in qualified expenses, so you took out $20,000 from your inherited 529 plan. If you then receive a $5,000 scholarship, your qualified expenses drop to $15,000, making $5,000 a non-qualified distribution. You can avoid having to pay taxes on the earnings portion of the $5,000 if you put $5,000 back into the 529 plan within 60 days of taking it out. If 60 days have already passed, you can't replace the distribution.

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