Are the withdrawals federal and state tax-free? Yes, as long as they do not exceed your adjusted qualified education expenses or, as the IRS calls, it “AQEE.” Here’s how the tax rules work:
Total the educational expenses:
The account beneficiary’s tuition and related fees for an undergraduate or graduate program;
- Room and board (but only if he or she carries at least half of a full-time load); and
- Books and supplies, computer and Internet access costs.
From the above costs, you subtract:
- Costs covered by Pell grants; tax-free scholarships, fellowships, tuition discounts and veterans’ educational assistance;
- Costs covered by employer-provided educational assistance or any other tax-free educational assistance (not including assistance received by a gift or inheritance);
- Expenses used to claim the American Opportunity or Lifetime Learning tax credit on your tax return; and
- Expenses used to claim the tax deduction for college tuition and fees on your tax return.
This total is the adjusted qualified education expense. If the withdrawals exceed this AQEE, then part of the earnings is taxable.
For example, if college expenses are $36,000 and tuition discounts and scholarships total $24,000, then the AQEE equals $12,000.
If a withdrawal is made from the 529 plan of $36,000, including $6,000 of interest, then only $12,000, or one-third (36,000/12,000) of the withdrawal, is being used for college, and therefore, only one-third of the $6,000 earnings, or $2,000, is tax-free, with taxes due on the $4,000 balance.
Determine what the AQEE will be and, possibly have the check, and therefore the 1099-Q, issued to the student whose tax liability on the $4,000 would probably be lower than the parents.
For state tax purposes, in this example, the $24,000 withdrawn and not used for educational expenses will be taxed, plus a penalty.