What Is Tax Recapture?

Tax Recapture Explained in Less than 4 Minutes

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Tax recapture is what happens when distributions from a tax-advantaged account are used for non-qualified expenses. In that case, those funds become subject to federal and/or state tax payments.

Learn more about what tax recapture is, how it works, and how it could impact you.

Definition and Examples of Tax Recapture

When you use distributions from a tax-advantaged account—such as a retirement fund or college education fund—for a non-qualified expense, you may be subject to tax recapture. Tax recapture means you have to pay taxes on those funds that you wouldn't have to pay if the money had been used for its intended purpose.

With retirement and college education funds, the amounts within these accounts often grow without being subject to income taxes. When withdrawals begin, there is usually some type of tax advantage.

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—tax recapture—can be imposed.

Consider the example of a college 529 savings plan. 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.

How Tax Recapture Works

When you contribute to a college 529 savings plan, you get to take tax deductions or tax credits from your income taxes over the years, with the promise that the money would be used for your child's educational purposes.

If that's not what the money is used for, 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. 

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. More than 30 states, including the District of Columbia, have such incentives available—which means you'd be looking at tax recapture in those places.

Important

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.

Tax Recapture Laws Vary by 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% California penalty tax on the earnings portion, but only if subject to the additional 10% federal additional penalty tax.

For New York’s Advisor-Guided or Direct College Savings Plans, the principal portion of rollovers and non-qualified 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% 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 do not include withdrawals made as the result of the beneficiary's death or disability. Nor do they include or 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.

Tax Recapture Exemptions

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

Note

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.

Exemptions to tax recapture 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.

Key Takeaways

  • If you take a non-qualified distribution from a tax-advantaged account, you may be looking at penalties in the form of tax recapture.
  • Tax recapture is common when it comes to college 529 savings accounts, as well as some retirement accounts.
  • Each state has different laws when it comes to tax recapture, so it's important to work with a qualified financial advisor who is familiar with your state's regulations.