Defining Tax Recapture

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There are many benefits of using tax-advantaged investments to achieve certain goals in life. Two of the best examples are using qualified accounts to save for retirement or a child’s future college education. In most cases, the amounts within these accounts grow without being subject to income taxes. When withdrawals begin, there is usually some type of tax advantage.

That, of course, is when everything goes as planned.

But life doesn’t always work out perfectly. Sometimes you need to make withdrawals from these plans before a specified date, or the proceeds are needed for other purposes. That is when adverse tax consequences can be imposed.

College 529 Savings Plans

College 529 savings plans are a perfect example of this situation. When accumulated over the years and distributed for qualified education expenses, they can substantially lessen the amount of financial aid required. But, if distributions are used for non-qualified purposes, they can be subject to a tax recapture.

Basically, you have been taking tax deductions or tax credits from your income taxes over the years with the promise of using the money for your child’s college education. If that doesn’t happen for some reason, the gains portion may be subject to a federal income tax penalty. In addition, you may be required to go back and pay the state taxes you otherwise would have paid on those amounts. Use this review to improve your understanding of tax recaptures, including whether or not you're at risk.

Tax Recaptures and College Financial Planning

In college financial planning situations, tax recaptures occur most often when a non-qualified distribution is taken from a Section 529 plan which a taxpayer contributed to, and then claimed a tax benefit for that year’s contribution. Although there is no federal income tax deduction for contributing to 529 college savings programs, certain states may seek a tax recapture of income tax due if you were able to deduct the original contributions on your state income tax return. Over 30 states, including the District of Columbia, have such incentives available.

If there is any chance that you will be taking a non-qualified distribution, it is very important that you understand the tax recapture provisions of your particular state.

California, for example, doesn't have a state tax deduction, so there is no recapture. That being said, a non-qualified withdrawal by a California taxpayer is subject to an additional 2.5 percent California penalty tax on the earnings portion, but only if subject to the additional 10 percent federal additional penalty tax.

For New York’s Advisor-Guided or Direct College Savings Plans, the principal portion of rollovers and nonqualified withdrawals is subject to New York tax to the extent of prior New York tax deductions, but only after removal of non-deducted contributions. In Indiana, the account owner must pay a tax equal to 20 percent 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 do not include withdrawals made as the result of the beneficiary's death or disability, or withdrawals made on account of the beneficiary's receipt of a scholarship. In this state, recapture also applies to any account terminated within 12 months from the account opening date.

Tax Recapture Exemptions

Unqualified distributions subject to a tax recapture generally include any distribution that is not for higher education purposes, often even including a rollover to another state's college savings program.

But there are some situations where you might not have to pay the federal income tax or 10% penalty or be subject to the state tax recapture provision.

These would include the death of the beneficiary, distributions due to a disability, attendance at a U.S. military academy, or receipt of sufficient financial aid, grants, or other assistance to cover the college expenses.

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 to 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.