How Do I Fix an Non-Qualified Distribution from a College Savings Plan?
April 04, 2011
I had a CollegeSure CD for my son who started college last fall. After the CD matured in August, I cashed it out and put the money in a savings account thinking I had to do that. He didn’t have enough college expenses for the first semester to equal the gross distribution, so now I think we’re in a terrible tax situation. I guess I was supposed to roll it into a 529 plan? I didn’t think to ask what my options were. We didn’t spend most of the money, it’s still in my son’s savings account. Am I just going to have to bite the bullet and pay taxes on all that money? — L.M.
If the proceeds from the CollegeSure CD were placed into a savings account with College Savings Bank (the bank that provides the CollegeSure CD), then the proceeds were probably not considered a distribution. College Savings Bank provides a special savings account to hold matured CollegeSure CD funds until the family is ready to make a qualified distribution. As noted in their disclosure statement this is one of the default actions that can occur upon maturity.
If the proceeds were deposited in a savings account (as opposed to a 529 college savings plan or other qualified tuition plan) with another financial institution, that counts as a distribution. You would have submitted a Distribution Authorization Form to do this.
If the proceeds count as a distribution, you should have received IRS Form 1099-Q Payments From Qualified Education Programs (Under Sections 529 and 530) by January 31. The gross distribution shows up in box 1 and the earnings portion of the distribution in box 2.
If you did not spend all of the money on qualified higher education expenses within the tax year, then the part that was not spent on qualified higher education expenses is considered an non-qualified distribution. The earnings portion of the distribution is distributed proportionally among the qualified and non-qualified shares of the gross distribution.
The earnings portion of an non-qualified distribution will be subject to ordinary income tax plus a 10% tax penalty. (The taxes are reported on the federal income tax return of the beneficiary, not the account owner.)
The 10% tax penalty is waived in certain circumstances, such as when the beneficiary receives a tax-free scholarship, employer educational assistance or veterans’ educational assistance, but only to the extent of the scholarship or assistance payment. This only affects the 10% tax penalty; you still pay ordinary income taxes on the earnings portion of the non-qualified distribution.
If 60 days or less have passed from the date of the distribution, you can avoid the income tax and the 10% tax penalty by rolling over the funds into a 529 plan or other qualified tuition plan. In such a situation the distribution is not considered a taxable distribution.
If you did not have enough qualified higher education expenses because you used up to $4,000 in tuition, fees and course material expenses to qualify for the Hope Scholarship Tax Credit (also known as the American Opportunity Tax Credit), you must choose whether to keep the tax credit or the tax-free distribution. You can’t do both. The same qualified higher education expenses can be used to justify only one tax benefit. You can’t double dip and use the same expenses to justify both the tax credit and a tax-free distribution from a 529 college savings plan. Keep the tax credit because it yields a greater financial benefit than the tax-free distribution from a 529 plan or other qualified tuition plan. The tax credit is based on the full amount spent for qualified higher education expenses, while the tax-free distribution avoids income tax and the 10% tax penalty on just the earnings portion of the distribution. The tax credit is also based on a higher percentage rate than the tax-free distribution.
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