529 - Scholarship Withdrawal Timing

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johne417
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529 - Scholarship Withdrawal Timing

Post by johne417 » Fri Oct 27, 2017 11:51 am

I have a 529 account for my daughter with $65K in it. Cost basis is $20K, so $45K gains. She applied to a public in-state university for fall '18, and its costs are roughly: $10K tuition (in-state), $10K room/board, plus books, some fees, etc. She's leaning to having an initial Major of "Undecided", where she'd have a year to choose a major, though even once she does it could theoretically change later.

Based on her test scores and the university's website, she'd qualify for the "Scholars Award" merit scholarship for $10K/yr, so $40K total. I understand this allows me to withdraw $40K from the 529 without the 10% tax penalty on the gains.

Now, if my D ends up going for any type of postsecondary schooling (grad school, nursing, dental, whatever), I would like to keep all the money in the 529 for that use. However, if she doesn't, I'd like to withdraw the full scholarship amount of $40K without the 10% gains penalty. Obviously I will not know this for a few years.

To avoid the tax penalty, do I have to take the full scholarship withdrawal immediately (entire $40K the year it's awarded), or do I do $10K/yr each of the 4 years the scholarship applies, or could I wait 3-4 years and still take full the withdrawal without the penalty?

Thanks in advance!

Spirit Rider
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Re: 529 - Scholarship Withdrawal Timing

Post by Spirit Rider » Fri Oct 27, 2017 4:46 pm

You have to take it in the year it applied. Since it will probably be applied for each semester it will actually be $5K, $10K, $10K, $10K and $5K

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ray.james
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Re: 529 - Scholarship Withdrawal Timing

Post by ray.james » Fri Oct 27, 2017 5:02 pm

Spirit Rider wrote:
Fri Oct 27, 2017 4:46 pm
You have to take it in the year it applied. Since it will probably be applied for each semester it will actually be $5K, $10K, $10K, $10K and $5K
Spirit rider an extended question,

If OP withdraws and contributes immediately to the same account, will it get a step up basis? That way will it solve the purpose that OP intends for future use?

(Note: account in this case is already established and OP's daughter has until she turns 30.)

Thank you.
When in doubt, /forum/viewtopic.php?f=1&t=79939

Spirit Rider
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Re: 529 - Scholarship Withdrawal Timing

Post by Spirit Rider » Fri Oct 27, 2017 5:05 pm

ray.james wrote:
Fri Oct 27, 2017 5:02 pm
If OP withdraws and contributes immediately to the same account, will it get a step up basis? That way will it solve the purpose that OP intends for future use?
Yes, but the gains of the withdrawal are still subject to ordinary income tax. Seems counter-productive to me.

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ray.james
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Re: 529 - Scholarship Withdrawal Timing

Post by ray.james » Fri Oct 27, 2017 5:10 pm

Spirit Rider wrote:
Fri Oct 27, 2017 5:05 pm
ray.james wrote:
Fri Oct 27, 2017 5:02 pm
If OP withdraws and contributes immediately to the same account, will it get a step up basis? That way will it solve the purpose that OP intends for future use?
Yes, but the gains of the withdrawal are still subject to ordinary income tax. Seems counter-productive to me.
Ahh I see, it is only penalty that is waived.(of course now that makes sense, no clue why I assumed otherwise.)
When in doubt, /forum/viewtopic.php?f=1&t=79939

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CollegePrudens
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Re: 529 - Scholarship Withdrawal Timing

Post by CollegePrudens » Fri Oct 27, 2017 10:25 pm

I have an older (2013-2014) library copy of "The best way to save for college" by Joseph Hurley. On page 163 it says:
... The IRS has not indicated whether the distribution must occur in the same year as the receipt of the scholarship in order to be eligible for the penalty waiver - some tax experts feel it is permissible to look for scholarships received in prior years whenever a nonqualified distribution is taken.
So the book is less strict than what "Spirit Rider" indicates. That said, there may have been changes/rules since 2013/14 that make the IRS's position clearer. If you have access to more recent version of this book in your local library, you may want to double check.
johne417 wrote:
Fri Oct 27, 2017 11:51 am
To avoid the tax penalty, do I have to take the full scholarship withdrawal immediately (entire $40K the year it's awarded), or do I do $10K/yr each of the 4 years the scholarship applies, or could I wait 3-4 years and still take full the withdrawal without the penalty?

Thanks in advance!
Live as if you were to die tomorrow; learn as if you were to live forever - Gandhi

Spirit Rider
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Re: 529 - Scholarship Withdrawal Timing

Post by Spirit Rider » Sat Oct 28, 2017 12:18 am

There IRS has indicated how this is handled.

Publication 970 Tax Benefits for Education, Chapter 8. Qualified Tuition Program (QTP)

Figuring the Taxable Portion of a Distribution
To determine if total distributions for the year are more or less than the amount of qualified education expenses, you must compare the total of all QTP distributions for the tax year to the adjusted qualified education expenses.

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

QTP distributions are compared to Adjusted Qualified Education Expenses (AQEE) for the same tax year. Scholarships reduce the AQEE. The taxable earnings are computed from the QTP distributions, AQEE and the total earnings. The amount of the taxable earnings attributable to the scholarships are exempt from the 10% excise tax.

This is the whole point of withdrawing the scholarship money, to avoid the 10% excise tax. It all tracks from the tax year of non-qualified distributions for scholarships.

I have first experience with this, because I am currently undergoing a CP-2000 correspondence audit. While it is not about scholarships, the IRS is most definitely reconciling distributions with AQEE in the same tax year.

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CollegePrudens
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Re: 529 - Scholarship Withdrawal Timing

Post by CollegePrudens » Sat Oct 28, 2017 8:47 am

Spirit Rider wrote:
Sat Oct 28, 2017 12:18 am
I have first experience with this, because I am currently undergoing a CP-2000 correspondence audit. While it is not about scholarships, the IRS is most definitely reconciling distributions with AQEE in the same tax year.
Very useful to know. Thanks for the post.
Live as if you were to die tomorrow; learn as if you were to live forever - Gandhi

johne417
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Re: 529 - Scholarship Withdrawal Timing

Post by johne417 » Mon Oct 30, 2017 10:47 am

Ditto what CollegePrudens said, thanks for the very useful info Spirit Rider.

It doesn't really change much, but cost basis was actually $40K not $20K. 20 (distributions) x 2 (k/distribution) ≠ $20k, #MathIsHard. :)

I guess I'll take the withdrawal and available scholarship reduction to AQEE year by year, and just hope Ms. Indecisive decides her path before too long. I might even explain the situation to her at some point, as a slight prod.

Thanks again!

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