Latest / The College Savings Podcast with Fexingo: 529 Plans, Education Funding, and Student Costs / The Kiddie Tax Trap in 529 Plan Withdrawals
Transcript
- Lucas: So you've saved diligently in a 529 plan for years. Your kid finally heads off to college. You take a withdrawal to pay tuition — and then find out the IRS wants a cut of that money. Not because of any penalty, but because of something called the kiddie tax. Luna: The kiddie tax — that's the rule that taxes a child's unearned income at the parent's marginal rate, right? But how does that apply to 529 withdrawals? Lucas: Exactly. The kiddie tax was created back in 1986 to prevent parents from shifting investment income to their kids to take advantage of a lower tax bracket. And for years, it worked the way you just described: a portion of a child's unearned income above a threshold got taxed at the parent's rate. Lucas: But the Tax Cuts and Jobs Act of 2017 changed the rules significantly. For tax years 2018 through 2025, the kiddie tax rate is based on the tax brackets for trusts and estates, not the parent's rate. And those trust brackets are much more compressed — you hit the top bracket at around thirteen thousand dollars of income. Luna: So the threshold is lower and the rates are potentially higher. What's the actual dollar amount that triggers the kiddie tax in 2025? Lucas: For 2025, the first one thousand three hundred dollars of a child's unearned income is tax-free. The next one thousand three hundred dollars is taxed at the child's rate. Anything over two thousand six hundred dollars gets hit by the kiddie tax — at trust rates. Luna: And a 529 withdrawal counts as unearned income if it's used for non-qualified expenses. But we're talking about qualified withdrawals here — paying tuition, room and board. Those should be tax-free. Lucas: They are tax-free for federal income tax purposes, yes. But here's the trap: if the student receives financial aid — say a scholarship that covers tuition — and then the family takes a 529 withdrawal for the same expenses, the withdrawal can become partially taxable. And that taxable portion counts as unearned income. Lucas: But even more common: a student who has a summer job or an internship and also gets a 529 distribution for room and board. The room and board portion is qualified, so no penalty. But the earnings portion of that distribution is still income that goes on the student's tax return. Luna: Wait — earnings from a 529 distribution for qualified expenses are tax-free at the federal level. That's the whole point of a 529 plan. How can they be taxable income? Lucas: They're not taxable. You're right. The earnings come out tax-free for qualified expenses. But the student's tax return still reports the distribution, and the IRS wants to know that the expenses were indeed qualified. The student's adjusted qualified education expenses — that's AQEE — determine how much of the earnings are tax-free. If the AQEE is less than the distribution, the excess earnings are taxable income. Luna: Ah — so the trap is when the student's qualified expenses are lower than the 529 distribution. That can happen if they get a scholarship, or if they live at home and the room and board allowance is lower than the distribution. Lucas: Exactly. And that taxable earnings portion becomes unearned income for the student. If the student also has a part-time job, their total income — earned plus unearned — can push them over the two thousand six hundred dollar threshold. Then the kiddie tax kicks in, and that earnings portion gets taxed at trust rates. Lucas: Trust rates start at ten percent for the first three thousand one hundred dollars or so, but jump to twenty-four percent pretty quickly. And the top rate of thirty-seven percent hits at just over thirteen thousand dollars. So a student with a ten thousand dollar internship and a five-thousand-dollar taxable 529 earnings portion could face a tax bill of over two thousand dollars. Luna: Ouch. That's a real bite. And the student probably doesn't expect it because they think of 529 withdrawals as always tax-free. So what's the workaround? Lucas: There's a really powerful one called the 'parental election.' The IRS allows parents to elect to include the child's unearned income on their own tax return instead of the child's. This applies when the child's unearned income is between one thousand three hundred dollars and twelve thousand five hundred dollars for 2025. Luna: So instead of paying trust rates, the income gets taxed at the parent's marginal rate — which could be lower or higher depending on the parent's bracket. Lucas: Right. For many families, the parent's rate — even at twenty-two or twenty-four percent — is lower than the compressed trust rates. And the parental election also avoids having to file a separate tax return for the child. But there's a catch: the election must be made by the due date of the parent's return, including extensions. You can't go back and amend. Luna: And it only applies to unearned income. So the student's earned income from a job is still taxed separately at their own rate, which is usually zero for the first fourteen thousand six hundred dollars in 2025. Lucas: That's right. So the strategy becomes: plan the timing and amount of 529 withdrawals carefully. If the student has a high-earning summer internship, maybe take a smaller 529 distribution that year and spread it out. Or coordinate the parental election to keep the overall tax bill manageable. Lucas: Let me give you a concrete example. Say a student has a summer internship earning eight thousand dollars. They also receive a ten thousand dollar 529 distribution for room and board. Their actual room and board costs are nine thousand dollars, so one thousand dollars of the distribution's earnings — let's say three hundred dollars of earnings — becomes taxable. That three hundred dollars pushes their unearned income over the threshold. Without the parental election, they pay kiddie tax at trust rates on that three hundred. Luna: And with the parental election, that three hundred gets added to the parents' income and taxed at their rate. If the parents are in the twenty-two percent bracket, that's sixty-six dollars in tax. Under trust rates, it could be a hundred and twenty or more. Lucas: Exactly. It's not a huge difference in this case, but it scales. For a student with a five-thousand-dollar taxable earnings portion, the difference could be over a thousand dollars. And there's another layer: state taxes. Some states conform to the kiddie tax rules, others don't. California, for example, does not apply the trust rate structure — it uses the parent's rate. So families in California might have a simpler situation. Luna: This is exactly the kind of detail that most families don't discover until tax season. And by then, the 529 distribution is already spent. Lucas: That's why I want to give listeners a practical checklist. Number one: before taking any 529 distribution, estimate the student's total income for the year — both earned and unearned. Number two: calculate the qualified expenses to see if any portion of the distribution could become taxable. Number three: if the student's unearned income exceeds two thousand six hundred dollars, consider the parental election and compare the tax outcomes. And number four: consider timing — maybe take the distribution in a year when the student has lower earned income. Luna: That's a solid framework. And it's worth noting that the Tax Cuts and Jobs Act provisions on the kiddie tax are set to expire after 2025. So the rules might revert to the pre-2018 structure — taxing at the parent's rate — starting in 2026. That could simplify things, but it also might change the strategy. Lucas: Great point. Congress could extend the current rules or let them lapse. Families with students who will be in college in 2026 and beyond should stay tuned. The good news is that the SECURE 2.0 Act already made 529-to-Roth rollovers possible, which gives families more flexibility if the child doesn't need all the funds. But the kiddie tax is still a very real issue for anyone taking distributions now. Luna: And if I'm a financial advisor or a parent listening, the takeaway is clear: don't assume 529 withdrawals are always tax-free. Understand how they interact with the student's other income. And if the numbers are significant, run the math on the parental election or consult a tax professional. Lucas: Absolutely. The 529 plan is still one of the best tools for education savings. But like any tax-advantaged account, it comes with rules. And the kiddie tax is one of those rules that can sneak up on you. A little planning goes a long way.