Author: Leon Clinton

You can accumulate federal income-tax-free earnings with a Section 529 college savings plan account.

Then, you can take federal-income-tax-free withdrawals to cover qualified education expenses, usually for college.

Great! But what if your designated account beneficiary decides not to attend college?

What are your options, and what are the federal income tax consequences for those options?

Exercise Patience

Your wavering account beneficiary may still decide to go to college after spending some time doing something else.

Unless the 529 plan restricts how long the account can remain open, you can leave the funds invested for years. The money will be there if your beneficiary decides to go to college later.

Change the Account Beneficiary

If you funded the 529 account with your own money, you are the account owner and can designate the account beneficiary.

As the account owner, you can also change the beneficiary.

You can change the beneficiary on a tax-free basis as long as the new beneficiary has one of the following family relationships with the original beneficiary:

• spouse,
• sibling,
• step-sibling,
• first cousin, or
• spouse of first cousin.

Less likely individuals include the original beneficiary’s brother-in-law or sister-in-law.

Much less likely individuals include the original beneficiary’s

• child,
• stepchild,
• foster child,
• adopted child,
• other descendent,
• son-in-law,
• daughter-in-law,
• parent,
• step-parent,
• father-in-law,
• mother-in-law,
• niece or nephew or their spouse, or
• aunt or uncle or their spouse.

Depending on the 529 plan, you can fill out a beneficiary change form online or print and mail it in.

You can also do a tax-free rollover of a 529 account balance into a new account set up for a new beneficiary with one of the above-listed family relationships to the original account beneficiary.

Warning. If the 529 account was funded with money from a custodial account that was set up for the person who is the account beneficiary, that person is the account owner as well as the account beneficiary. So, the funds in the 529 account belong to that person.

If you are the custodian of the 529 account, you are legally obligated to manage the account for the account beneficiary’s benefit, and you don’t have the power to change the beneficiary.

Once the beneficiary becomes an adult under applicable state law, that person assumes legal control over the 529 account. That person could then change the beneficiary to one of the aforementioned family members on a tax-free basis or arrange for a tax-free rollover to one of those family members.

Take Advantage of the Broad Definition of Qualified Education Expenses

You can take tax-free 529 account withdrawals to pay for technical and professional schools as long as the educational institution participates in financial aid programs sponsored by the U.S. Department of Education. Almost all postsecondary educational institutions will pass that test.

You can also take tax-free 529 account withdrawals to cover expenses to attend a registered apprenticeship program.

You can take tax-free 529 account withdrawals to pay up to $10,000 of annual K-12 tuition expenses.

You might do the K-12 withdrawal for a new account beneficiary with one of the family relationships to the original beneficiary. Or you might set up a new account for someone with one of those relationships and fund it with a rollover from the original beneficiary’s 529 account.

Finally, you can take tax-free 529 account withdrawals to cover principal or interest payments on qualified education loans owed by the account beneficiary or a sibling of the beneficiary, subject to a lifetime limit of $10,000.

Take Tax-Free Withdrawals for Your Education Expenses

Suppose you funded the 529 account with your own money (as opposed to funding the account with money from a custodial account set up for the Section 529 account beneficiary). In that case, you can change the account beneficiary to yourself, return to school, and take tax-free withdrawals to cover your qualified education expenses.

Drain the Account

If you choose this option, you pay taxes on the earnings included in your withdrawals that you use for other than qualified education expenses. And you likely have to pay the 10 percent penalty tax on those earnings.

Warning. You may not take money out of a 529 account if it was initially put there from a custodial account that was created for the person who is supposed to benefit from the 529 account.

Any money taken from the 529 account legally belongs to the custodial account beneficiary and can only be used to benefit that person—such as buying your 20-year-old non-student a car.

Once the beneficiary becomes an adult under applicable state law, that person assumes legal control over the 529 account and can do whatever he or she wants with the money, subject to the tax considerations explained here.

If you would like to discuss your 529 account, please call me on my direct line at 408-778-9651.

• By Leon Clinton
• February 27, 2024

The United States has a “pay as you go” tax system in which payments for income tax (and, where applicable, Social Security and Medicare taxes) must be made to the IRS throughout the year as income is earned, whether through withholding, by making estimated tax payments, or both.

You suffer an estimated tax penalty if you don’t pay enough to the IRS during the year.

The IRS levies this non-deductible interest penalty on the amount you underpaid each quarter. The penalty rate equals the short-term interest rate plus three percentage points.

Due to the rise in interest rates, the current penalty rate is 8 percent—the highest in 17 years. And since it’s not deductible, the net cost likely far exceeds 8 percent.

If you’re an employee and have all the tax you owe withheld by your employer, you don’t have to worry about this penalty.

But you must worry about it if you’re self-employed because no one withholds taxes from your business income. Likewise, you must worry if you receive income from which no, or not enough, tax is withheld—for example, retirement distributions, dividends, interest, capital gains, rents, and royalties.

C corporations are also subject to the underpayment of estimated tax penalty.

Fortunately, it’s easy to avoid this penalty!

• All individual taxpayers have to do is pay (1) 90 percent of the total tax due for the current year or (2) 100 percent of the total tax paid the previous year (110 percent for higher-income taxpayers with adjusted gross incomes of more than $150,000 ($75,000 for married couples filing separately).
• Corporations must pay 100 percent of the tax shown on their return for the current or preceding year (but large corporations can’t use the prior year).

Most individuals and corporations make equal quarterly estimated tax payments to the IRS. The IRS applies the penalty separately for each payment period. Thus, you can’t reduce the penalty for one period by increasing your estimated tax payments for a later period. This is true even if you’re due a refund when you file your tax return.

Some individuals and corporations can use alternate methods for computing estimated taxes, such as the annualized income method. But the alternate methods can be complicated.

If you want to discuss your estimated taxes, please call me on my direct line at 408-778-9651.

• By Leon Clinton
• February 20, 2024

First question: Is your employee retention credit (ERC) claim improper? Are you sure? If you’re sure, the IRS has a proposition for you.

Pay back 80 percent of all your ERC claims, and keep the remaining 20 percent.

You read that right.

Say you made an improper employee retention credit claim, received the improper cash, and put that improper cash in your bank account.

Now, because the claim was wrong, you return 80 percent of the credit to the IRS and keep the remaining 20 percent, including interest. That’s a good deal.

But it gets even better.

Your 20 percent is tax-free. And you get to keep the interest you received on the 100 percent.

Example. In 2023, you amended some of your 2020 and 2021 payroll tax returns using IRS Form 941-X and collected $200,000 in ERC cash plus $12,000 of interest from the IRS. Now, however, you realize that was wrong. No problem! Just complete some IRS paperwork to qualify, wait for approval, and then return $160,000. You keep the rest—$40,000 is tax-free ($200,000 – $160,000), and $12,000 is taxable.

Why Is the IRS Doing This?

With the 80 percent payback deal, the IRS has you name the tax preparers, payroll processing companies, and ERC scammers who filed or helped you file your improper claim.

You give the IRS their names, addresses, and telephone numbers, and you tell the IRS what services they provided in connection with the improper claim.

Why 80 Percent?

The IRS reasons that you likely paid a percentage fee for help with your improper ERC claim, and thus you never received the full amount of the credit—therefore, the 80 percent.

Be Quick! Time for Filing Is Short

You must first request to claim $0 ERC before midnight on March 22, 2024. You do this electronically using IRS Form 15434.

Next, the IRS reviews your application package and mails you a letter telling you whether your application is accepted or rejected.

Accepted. If your application is accepted, the IRS mails you a closing agreement. You must sign and return the closing agreement within 10 days of the date of mailing by the IRS—so stay alert.

You make your multiple 80 percent repayments as directed by Form 15434 using the Electronic Federal Tax Payment System (EFTPS). You should make these payments at the same time you sign and submit the closing agreement.

Key point. Don’t let the Form 15434 instructions confuse you (they can be confusing). Here are the steps you need to follow for the 80 percent payback deal:

1. Complete IRS Form 15434.
2. Wait for the acceptance or rejection letter. If accepted, wait for the closing agreement.
3. Sign and send the closing agreement to the IRS.
4. On the day you send the closing agreement to the IRS, use EFTPS to make your multiple 80 percent payments.

Form 15434 makes it sound like you should submit the multiple payments when you complete the form. The IRS states in its FAQs: “Paying at the time you apply for the ERC-VDP can help speed up processing and resolve your case more quickly.”

Recommendation. Wait for the closing agreement before paying. If you pay upfront, here is what happens:

• Your money is in limbo for the time it takes the IRS to process your claim.
• The IRS could reject your claim—and because you paid upfront with the form, the IRS now has your money.

Rejected. If the IRS rejects your application, it will explain why in its rejection letter and will offer potential solutions.

The Big Question: Should You Go for the 80 Percent?

Before doing anything, check your ERC claim. Is it valid?

It’s possible that many small businesses that qualify for the ERC will mistakenly do the 80 percent deal—to their detriment. Think back to the example in the opening of this article:

• If the claim is valid, you win by $200,000.
• If the claim is invalid, you win by $40,000.

That’s a $160,000 difference. Nothing to sneeze at.

Key point. Confirm whether your claim is valid or invalid before taking action.

Criminal Aspect

Executing the 80 percent closing agreement does not preclude the IRS from investigating you for any associated criminal conduct or recommending prosecution for violation of any criminal statute, and does not provide any immunity from prosecution.

If you want to discuss the ERC payback deal, please call me on my direct line at 408-778-9651.

• By Leon Clinton
• February 16, 2024