Man Fails to Consult with Wife About Sec. 529 Withdrawal – Tax Disaster Ensues

You can take tax-free withdrawals from a Section 529 college savings plan if you use the withdrawal to pay for college expenses.  If you withdraw the money for other reasons, you’re taxed on the withdrawal and are subject to a 10% penalty.  As a taxpayer learned in Tax Court on Thursday, this is true even if you change your mind after you’ve withdrawn the money.

The taxpayer in the case was going through financial troubles in 2008 so he decided to withdraw $10,500 total from the three Section 529 accounts that had been set up for his kids.  He intended to use the money to pay household expenses.

Once the checks arrived, he talked to his wife about the situation.  She disagreed with his decision to withdraw the money.  So, the man immediately sent the checks back to the plan, with instructions to re-deposit the money back into his kid’s accounts.  The plan did so.

At the end of the year, the plan sent a 1099 showing the amount of the withdrawals.  The couple did not include this amount on their tax return.  Naturally, this caught the watchful eye of the IRS computers.  The IRS said the withdrawals were taxable.  The man disagreed and went to Tax Court.

The Tax Court agreed with the IRS.  The taxpayer tried to argue that because he sent the checks back, the withdrawals should be considered a tax-free rollover.  But the Court didn’t buy it:

Petitioner candidly admits … that he requested the distributions because he needed cash to pay household expenses and that he never contemplated any rollover of the distributions. Indeed, on petitioner’s request forms he selected “Non-Qualified Withdrawal” rather than “Withdrawal for Rollover” as his reason for taking the distributions.

On the bright side, the Court did feel sympathetic enough to waive the 10% early withdrawal penalty.

The moral is, make sure you really want to take the withdrawal — and talk to your spouse about it — before you have the checks cut!