What Is the Tax Treatment of a QTP Distribution?

A Qualified Tuition Program (QTP), or 529 plan, is a savings plan for future education costs. A distribution is the withdrawal of funds from the account. The main benefit of a QTP is that distributions are tax-free at the federal level, provided the money is used for specific, approved educational purposes. Understanding how these distributions are treated for tax purposes is important for maximizing the plan’s benefits and avoiding unexpected taxes or penalties.

Qualified Higher Education Expenses

The tax-free status of a QTP distribution depends on using the funds for Qualified Higher Education Expenses (QHEE), as defined by the IRS. These expenses include:

• Tuition and fees required for enrollment or attendance at an eligible educational institution.
• Books, supplies, and equipment required for the student’s courses.
• Room and board, if the student is enrolled at least half-time. The qualified amount cannot exceed the greater of the school’s official room and board allowance for financial aid or the actual amount charged for on-campus housing.
• A computer, peripheral equipment, computer software, and internet access, as long as these items are used primarily by the beneficiary during enrollment.
• Up to $10,000 per year, per beneficiary, for tuition at an elementary or secondary public, private, or religious school.
• A lifetime limit of $10,000 per person to pay the principal or interest on qualified education loans. This limit applies to the plan’s beneficiary and each of their siblings.

Calculating the Taxable Amount of a Distribution

If a QTP distribution is not used for qualified expenses, a portion may be taxable. A QTP account has two parts: contributions (the basis) and investment earnings. For a non-qualified distribution, only the earnings portion is subject to income tax and a penalty, while contributions are returned tax-free.

To find the taxable amount, you must calculate the earnings portion of the distribution. This is done on a pro-rata basis by multiplying the total distribution by a ratio of the account’s total earnings to its total value at the time of withdrawal. Your plan administrator provides these figures.

If a distribution covers both qualified and non-qualified expenses, you must allocate the earnings. For example, if you take a $10,000 distribution with $2,000 in earnings and only use $8,000 for QHEE, the $2,000 remainder is a non-qualified portion. You would find what percentage of the total distribution was non-qualified ($2,000 / $10,000 = 20%) and apply that to the earnings (20% of $2,000 = $400). In this case, $400 is taxable income.

Taxable earnings are reported as ordinary income and are also subject to an additional 10% federal tax penalty. Exceptions to the 10% penalty exist for events like the beneficiary’s death, disability, or receipt of a tax-free scholarship, but the ordinary income tax on the earnings still applies.

Tax Reporting for QTP Distributions

After a QTP distribution, the plan administrator issues Form 1099-Q, Payments From Qualified Education Programs. This form shows the gross distribution in Box 1, the earnings in Box 2, and the basis (your contributions) in Box 3. The recipient is responsible for determining the taxability of the distribution.

If the entire distribution was used for qualified expenses, you generally do not need to report it on your tax return as the transaction is tax-free. You should, however, keep records of the educational expenses to prove the funds were used correctly in case of an IRS inquiry.

If part of the distribution is taxable, it must be reported as “Other Income” on Schedule 1 of Form 1040. The additional 10% tax is calculated on Form 5329. The person who receives the distribution, either the account owner or the student, is responsible for reporting any taxable amount.

You cannot use the same expenses to justify both a tax-free QTP distribution and another education tax benefit, such as the American Opportunity Credit (AOC) or the Lifetime Learning Credit (LLC). Before calculating the tax-free portion of your QTP distribution, you must first reduce your total QHEE by any expenses used to claim one of these credits.

Special Distribution Rules and Rollovers

An account owner can perform a tax-free rollover of funds from one 529 plan to another for the same beneficiary once in any 12-month period. This allows for changing investment strategies or plan administrators without tax consequences.

Funds can also be rolled over from a 529 plan to an ABLE account, a savings account for individuals with disabilities. This provides flexibility if the funds are needed for disability expenses. The rollover is tax-free, but the amount is subject to the annual ABLE contribution limit.

The SECURE 2.0 Act allows for rollovers from a 529 plan to a Roth IRA for the beneficiary. This rule requires the 529 account to have been open for more than 15 years. Any contributions or earnings from the last five years are ineligible for this type of rollover.

The annual rollover amount is subject to the beneficiary’s Roth IRA contribution limit and cannot exceed their earned income for that year. A lifetime maximum of $35,000 can be rolled over per beneficiary. This offers an option for repurposing unused education funds for retirement savings without penalty.