The amounts within retirement and college education accounts often grow without the growth being subject to income taxes. There’s usually some type of tax advantage when withdrawals begin, too.
An Example of Tax Recapture
You get to claim tax deductions or tax credits over the years when you contribute to a college 529 savings plan with the promise that the money will be used for your child’s educational purposes. The gains portion may be subject to a federal income tax penalty if that’s not what the money is used for. You might also be required to pay the state taxes you otherwise would have paid on those amounts. Let’s say that you run into some surprise financial trouble. You have to pull money out of your 529 to pay for everyday expenses (non-qualified) rather than the education expenses the plan was designed for. Per the rules of your state’s 529 savings plan, you face a penalty for the withdrawal, and the state will want to recapture the money you saved by deducting your contributions.
Tax Recapture Laws Vary by State
States can set their own rules for tax recapture. Take California, New York, and Indiana, for example.
Califorina
California doesn’t have a state tax deduction for contributions for a 529 plan, so there’s no recapture there. But a non-qualified withdrawal by a California taxpayer is subject to an additional 2.5% California penalty tax on the earnings portion if it’s subject to a federal penalty tax.
New York
The principal portion of rollovers and non-qualified withdrawals for New York’s advisor-guided or direct college savings plans is subject to New York tax to the extent of prior New York tax deductions, but only after removal of non-deducted contributions.
Indiana
In Indiana, one of the state’s three plans charges a penalty of 20% of the non-qualified withdrawal from a 529 plan to the extent that any Indiana tax credits were previously claimed. Non-qualified withdrawals for this purpose may include rollovers. But they don’t include withdrawals made as the result of the beneficiary’s death or disability. Nor do they include withdrawals made on account of the beneficiary’s receipt of a scholarship. In Indiana, recapture also applies to any account terminated within 12 months from the account opening date in Indiana.
Tax Recapture Exemptions
Unqualified distributions subject to a tax recapture generally include any distribution that’s not for higher education purposes. This sometimes includes a rollover to another state’s college savings program. Exemptions to tax recapture include the death of the beneficiary, distributions due to a disability, and attendance at a U.S. military academy. It is very important that you understand both the tax benefits and potential tax consequences of investing in a 529 savings plan for your child’s education. Talk with a financial advisor who is knowledgeable about the specific tax codes in your state to determine how you might be affected by tax recapture exemptions.
