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A Cautionary Tale on 529 Tax Rules

The rules governing distributions, rollovers, and changes of beneficiaries are complex, and clients should consult their tax advisors first.

Susan T. Bart, 03/29/2012

A recent United States Tax Court case illustrates how easy it is to unintentionally violate the distribution and rollover rules under Code section 529 with disastrous results.

In Karlen v. Commissioner (T.C. Summary Opinion 2011-129, November 10, 2011), Tim Karlen had 529 accounts for his three children. Tim began to experience some financial difficulty when his income decreased because of the downturn in the national economy, and he requested distributions of $3,500 from each of the 529 accounts. On the request form, Tim indicated that the withdrawals were "nonqualified withdrawals" rather than "withdrawals for rollover." The 529 plan mailed the three checks to him.

After receiving the checks, Tim conferred with his wife about the distributions, and she persuaded him that they should not withdraw the money from the 529 accounts. Tim then informed a representative for the 529 plan that he did not wish to take the distributions. The representative told Tim that because no error had been made by the program in processing his request for distributions, the transactions could not be voided. The representative instructed Tim to endorse the three checks and return them if he wished to redeposit the amounts. Tim did so immediately.

When the 529 program received the three checks, it redeposited each one as a new contribution into the same account from which it had been withdrawn. Thereafter, Tim received a Form 1099-Q, Payments from Qualified Education Programs (Under Sections 529 and 530), from the 529 plan for each of the three distributions.

The IRS argued that the distributions were nonqualified distributions and that even though the uncashed checks were returned to the program, they still constituted nonqualified distributions followed by a recontribution. Further, the recontributions did not qualify as rollovers. Therefore, income tax and the additional penalty tax was assessed on the earnings portion of each distribution. Tim argued that the distributions should not be considered to have been received because he did not cash or deposit the checks, or alternatively that the recontributions should constitute a rollover.

The Tax Court concluded that the receipt of a check, even though it is not cashed or deposited, completed the distributions from the 529 accounts. The Tax Court also found that when Tim returned the checks to be recredited to the accounts, it did not constitute a valid rollover. In order to comply with the rollover rules, the rollover either needs to be to an account for the benefit of a different beneficiary or needs to be to a different program. Code section 529(C)(i) provides:

(C) CHANGE IN BENEFICIARIES OR PROGRAMS. –

(i) ROLLOVERS. – Subparagraph (A) shall not apply to that portion of any distribution which, within 60 days of such distribution, is transferred:

Susan T. Bart is a partner in the Private Clients, Trusts & Estates Group at Sidley Austin LLP in its Chicago office, where her practice includes estate planning, estate and trust administration, and fiduciary counsel. She has written two books, including Education Planning and Gifts to Minors published by Illinois Institute for Continuing Legal Education (iicle.com), which extensively discusses 529 plans.

She is the author of Education Planning and Gifts to Minors 2004 Edition. She is a frequent speaker on trust and estate topics in general and Section 529 college savings plans in particular.

The author is not an employee of Morningstar, Inc. The views expressed in this article are the author's. They do not necessarily reflect the views of Morningstar. The author is a freelance contributor to MorningstarAdvisor.com. The views expressed in this article may or may not reflect the views of Morningstar.
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