529 info for new Cadets and Parents Looking ahead

Haveaniceday

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Many parents use 529 funds to pay academy expenses, but it is a murky IRS area as the service academies are not considered colleges by the IRS, thus it is best avoided. It comes down to you cannot be a full time student and a member of the military fully employed at the same time. Let me explain:

When it comes tax time, the academy will not send your cadet a 1099-T like a civilian college will showing college expenses that were paid, and allowing you to claim your 529 draw against those 1099-T expenses. When you file taxes, the IRS basically matches the 1099 your state 529 plan issues you with the 1099-T from the college showing the tuition you paid and making you eligible to draw 529 funds. No 1099-T, no authorization for Qualified 529 draws. Service academies will have a Tax training for your cadet, so this will be explained to them. They will be told they are not to file as college students, but rather as members of the military which they are. They will be told they should not be claimed as dependents on their parents return, but to file as independent adults. Many people ask their state plan if they can draw their funds and are told incorrectly yes by the plan, but state law does not govern the federal tax code. The academies will also encourage the cadets to open an IRA either Roth or regular to make them eligible for the Retirement Savers Credit which will usually bring their Fed taxes to zero, and is also a great savings start. I note, if your cadet checks the college student box on the IRS from, they become in-eligible for the RSC; that is why they are told repeatedly not to file as a college student, but rather as a member of the military.

The best way to use 529 funds for your cadet is to take a non-qualified withdrawal where you will owe taxes on the gains you made. Since they are attending a service academy the 10% penalty is waived. This draw, if the check is made out to the cadet, is taxable income to them they must report on their return. But, since they only earn about 15K per year they are in a low tax bracket. You can draw a little each of the 4 years and keep them in a low bracket. If you follow academy advice and open a IRA they you will get access to the Retirement Savers Credit which will bring your tax down further and if done right, to zero with a draw of about 14K of 529 funds per year.

Some people ask, if all this is true, why do the academies allow me to send 529 funds to them to pay for uniforms etc. The answer is because they do not give out tax advice, just like the state 529 plans do not give out tax advice. For all they know, you did this as I described and took a NON-Qualified withdrawal, and everything is fine. If you try to make a qualified 529 draw (not subject to fed tax) and claim you have a full time student, that will conflict with the individual taxes your cadet files from the academy.

This is very complicated, but I hope this at least gives you enough to go to your tax adviser and discuss.

USMA 529 guidance attached below explains this in more detail.
 

Attachments

  • Army USMA tax information for parents (1).pdf
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To clarify, a few definitions:

Qualified Withdrawal = 529 funds are drawn to pay IRS authorized college expenses and the college generates a 1099-T reporting to the IRS what actual college payments they received from you (ie. tuition). A Qualified withdrawal is free from Fed and State tax.

Non-Qualified Withdrawal = 529 funds are withdrawn for any other purpose than a qualified withdrawal. Fed and State tax (varies by state) are owed on the investment gains you receive from a non-qualified 529 withdrawal. Also, a 10% penalty is due unless the funds are used for the child who attends a service academy. For example, you can draw 529 funds to put a pool in your backyard, you just have to pay the tax and the penalty.

Service Academies = For IRS purposes, they are not "eligible educational institutions" as defined by the Tax Code. The are simply a military assignment. The above USMA memo explains this in detail. Once parents realize the IRS does not view academies as colleges, they begin to understand why they cannot file for the various IRS college tax credits and cannot make qualified (tax free) withdrawals from their 529s for academy costs.

As to who is responsible for the tax on a non-qualified withdrawal, it is the person and more importantly the social security number that the funds are issued to. So if a parent makes a non-qualified withdrawal to themselves they will be taxed at their marginal tax bracket (probably 22% or higher). However, if the 529 plan is instructed to issue the funds to the child, the check will be issued in the cadets name and SSN and will be taxed at their much lower marginal tax rate (probably 10%). The 529 plan will send the funds to either and does not care, you have to make the specific request, and once funds are issued it is irrevocable. A mistake here can more than double your fed tax due, be careful.

Again, the USMA memo attached above is only 2 pages and spells this out pretty well. If you take it to your tax advisor, they can help with it. Being that it is on letterhead signed by a JAG officer it is the best quality guidance I have seen on 529s.
 
Last edited:
To clarify, a few definitions:

Qualified Withdrawal = 529 funds are drawn to pay IRS authorized college expenses and the college generates a 1099-T reporting to the IRS what actual college payments they received from you (ie. tuition). A Qualified withdrawal is free from Fed and State tax.

Non-Qualified Withdrawal = 529 funds are withdrawn for any other purpose than a qualified withdrawal. Fed and State tax (varies by state) are owed on the investment gains you receive from a non-qualified 529 withdrawal. Also, a 10% penalty is due unless the funds are used for the child who attends a service academy. For example, you can draw 529 funds to put a pool in your backyard, you just have to pay the tax and the penalty.

Service Academies = For IRS purposes, they are not "eligible educational institutions" as defined by the Tax Code. The are simply a military assignment. The above USMA memo explains this in detail. Once parents realize the IRS does not view academies as colleges, they begin to understand why they cannot file for the various IRS college tax credits and cannot make qualified (tax free) withdrawals from their 529s for academy costs.

As to who is responsible for the tax on a non-qualified withdrawal, it is the person and more importantly the social security number that the funds are issued to. So if a parent makes a non-qualified withdrawal to themselves they will be taxed at their marginal tax bracket (probably 22% or higher). However, if the 529 plan is instructed to issue the funds to the child, the check will be issued in the cadets name and SSN and will be taxed at their much lower marginal tax rate (probably 10%). The 529 plan will send the funds to either and does not care, you have to make the specific request, and once funds are issued it is irrevocable. A mistake here can more than double your fed tax due, be careful.

Again, the USMA memo attached above is only 2 pages and spells this out pretty well. If you take it to your tax advisor, they can help with it. Being that it is on letterhead signed by a JAG officer it is the best quality guidance I have seen on 529s.

Great info! and a burning follow-up question, would there be a difference in treatment between 529 funds and Coverdell ESA funds?
 
Thanks for sharing!

What if someone attended a university in the Spring (and used their 529 to pay college expenses), but became a cadet in June -- Would it be better to file as a college student and not make any non-qualified 529 withdrawals for the rest of the year, or can the legitimate university expenses be claimed even if filing as a member of the military?
 
The information above re: ‘no 1099-T, no authorization for qualified 529 draw’ is not exactly correct. Books, supplies, computers and internet access, as well as housing and food (even for off-campus students) are reasons for qualified 529 withdraws. There would be no 1099 issued for these items; the 529 owner simply attests that the funds withdrawn are being used for these items. 529 rules have been loosened over time since the inception of the plans in 1996.

But overall that is a great summary. Thanks for posting it!
 
The information above re: ‘no 1099-T, no authorization for qualified 529 draw’ is not exactly correct. Books, supplies, computers and internet access, as well as housing and food (even for off-campus students) are reasons for qualified 529 withdraws. There would be no 1099 issued for these items; the 529 owner simply attests that the funds withdrawn are being used for these items. 529 rules have been loosened over time since the inception of the plans in 1996.

But overall that is a great summary. Thanks for posting it!
Yes, you are correct thank you bringing this important point forward. I oversimplified my example because even though you are correct, those other eligible expenses (books, computers, etc.) flow from college attendance and tuition payments and since the academies are not colleges and do not issue 1099-T, then those ancillary costs are not fundable from qualified 529 draws. Even kids on full scholarship that do not pay tuition to a civilian college get a 1099-T from the school which also establishes their student status. Folks look for loopholes and of course, more power to them if they find a good one; to me better safe than sorry with the IRS and my kids tax returns.

Again, thank you for pointing this out as others may have noticed it as well and my shortcut may have caused confusion.
 
Thanks for sharing!

What if someone attended a university in the Spring (and used their 529 to pay college expenses), but became a cadet in June -- Would it be better to file as a college student and not make any non-qualified 529 withdrawals for the rest of the year, or can the legitimate university expenses be claimed even if filing as a member of the military?
Recommend you consult with your tax adviser on this as you have options but each one is very technical. Use the above attached USMA memo to discuss the matter with your CPA.
 
Great info! and a burning follow-up question, would there be a difference in treatment between 529 funds and Coverdell ESA funds?
529 is specific to college while ESA can be used while you're child even in elementary school.
 
529 is specific to college while ESA can be used while you're child even in elementary school.
As of 2019, qualified 529 expenses include tuition expenses for elementary, middle, and high schools (private, public, or religious). Although the money may come from multiple 529 accounts, only $10,000 total can be spent each year per beneficiary on elementary, middle, or high school tuition.

 
As of 2019, qualified 529 expenses include tuition expenses for elementary, middle, and high schools (private, public, or religious). Although the money may come from multiple 529 accounts, only $10,000 total can be spent each year per beneficiary on elementary, middle, or high school tuition.

That seems to have changed recently. Thanks for correcting me.
 
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