What Happens If I Close My 529 Account?

A 529 plan is a savings account with tax advantages for education expenses, allowing funds to grow federally tax-free. Withdrawals for qualified education costs are also tax-free. While many people use these accounts for college savings, changing circumstances can lead an owner to close the account. This decision involves a non-qualified withdrawal with specific financial and procedural implications.

Financial Consequences of Closing a 529 Account

When you close a 529 account and take a non-qualified distribution, the withdrawal is divided into two parts: the return of your original contributions and the earnings. Your contributions, often referred to as the basis, are returned to you free of federal tax and penalties because you made these contributions with after-tax dollars.

The earnings portion of the withdrawal, however, faces two primary financial consequences at the federal level. These earnings are subject to ordinary income tax at your marginal tax rate for the year of the withdrawal. The IRS also imposes an additional 10% penalty tax on these earnings.

Beyond federal taxes, there are state-level financial considerations. If you previously claimed a state income tax deduction or credit for your contributions, closing the account will trigger a recapture of that tax benefit. This means you will have to pay back the tax savings on your state income tax return.

Certain situations allow you to avoid the 10% federal penalty on the earnings, though the earnings are still subject to ordinary income tax. These exceptions include:

• The death or disability of the account beneficiary.
• The beneficiary receives a scholarship, allowing a penalty-free withdrawal up to the scholarship amount.
• The beneficiary attends a U.S. Military Academy.
• The funds are used for expenses that were used to claim the American Opportunity Tax Credit or Lifetime Learning Tax Credit.

Calculating the Taxable Portion of a Withdrawal

To determine the taxable amount, you must first identify the total value of your account and the total amount of earnings at the time of the withdrawal. These figures are readily available on your account statements provided by the 529 plan administrator. The calculation involves determining the proportion of the account’s value that consists of earnings and applying that same proportion to your withdrawal amount.

The formula is as follows: your total withdrawal amount is multiplied by a fraction, where the numerator is the total earnings in the account and the denominator is the total account value. For instance, if your account is worth $50,000, of which $15,000 is earnings, the earnings ratio is 30% ($15,000 / $50,000). If you close the account and withdraw the full $50,000, the taxable portion of that withdrawal would be $15,000 ($50,000 x 0.30).

This calculation ensures that every dollar withdrawn is treated as being partly a return of principal and partly a distribution of earnings. Your plan administrator will perform this calculation and report the gross distribution and the taxable earnings to you and the IRS. You can find these specific amounts in Box 1 and Box 2 of the Form 1099-Q you will receive.

The Process for Closing Your Account

The process of closing your 529 account is a direct administrative task. The first step is to contact your 529 plan administrator, which can be done through their online portal or by calling their customer service number.

You will need to formally request a full distribution of your account balance and the closure of the account. To process this request, the plan administrator will require you to verify your identity as the account owner.

Once your request is submitted and verified, the plan administrator will liquidate the investments in the account and process the payment. You can choose to receive the funds via a physical check mailed to your address of record or through an electronic funds transfer to your bank account. The timeline for receiving the funds takes several business days.

As a result of this transaction, the 529 plan is required to issue IRS Form 1099-Q, Payments From Qualified Education Programs. You will receive this form in the mail during the following tax season, by the end of January. This document is important as it reports the withdrawal details needed for your tax return.

Reporting the Withdrawal on Your Tax Return

After closing your account and receiving your funds, the final step is to correctly report the transaction to the IRS on your annual tax return. The information you need is provided on Form 1099-Q. This form details the gross distribution in Box 1 and the earnings portion in Box 2.

The taxable earnings amount from Box 2 of Form 1099-Q must be reported as “Other Income” on Schedule 1 of your Form 1040. This amount is then added to your other income to calculate your adjusted gross income for the year and is taxed at your regular federal income tax rate.

The 10% additional tax on the earnings must be calculated and reported separately. You will use Form 5329, Additional Taxes on Qualified Plans (including IRAs) and Other Tax-Favored Accounts, to do this. On this form, you will enter the taxable earnings amount and calculate the 10% penalty.

The total penalty calculated on Form 5329 is then carried over to Schedule 2 of your Form 1040, where it is added to your total tax liability. If you qualify for an exception to the 10% penalty, you will still report the earnings as income but will indicate the exception on Form 5329 to avoid the additional tax.