Definition and Examples of Tax Recapture
You may be subject to 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. Tax recapture means you have to pay taxes on those funds that you wouldn't have had to pay if the money had been used for its intended purpose.
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.
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. This is when adverse tax consequences such as tax recapture can be imposed.
A college 529 savings plan can substantially lessen the amount of financial aid required when they accumulate over the years and are distributed for qualified education expenses. But the funds can be subject to a tax recapture if distributions are used for non-qualified purposes.
How Tax Recapture Works
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.
There's no federal income tax deduction for contributing to 529 college savings programs, although they're authorized by Section 529 of the Internal Revenue Code. They're sponsored by educational institutions, states, and state agencies.
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.
It's very important that you understand the tax recapture provisions of your particular state if there's any chance that you might have to take a non-qualified distribution.
Tax Recapture Laws Vary by State
California doesn't have a state tax deduction, 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 subject to the additional 10% federal penalty tax.
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.
The account owner must pay a tax equal to 20% of the non-qualified withdrawal from a 529 plan in Indiana 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.
There are some situations in which 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 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.
- 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.
Frequently Asked Questions (FAQs)
Do all states offer incentives for investing in 529 plans?
More than 30 states, including the District of Columbia, have such incentives available. You'd be looking at tax recapture in those places.
What are some other types of plans that might be subject to recapture?
Tax-exempt mortgage bonds can be subject to recapture at the federal level, as can some state-level investment tax credits.