In case you happened to miss it, the Illinois legislature last year passed an addition to the Revenue Code that requires recapture of deductions that you may have taken for contributions to one of the Illinois 529 plans.
529 Contribution Deduction Recapture
For years, the Illinois 529 plans – BrightStart, Bright Directions, and College Illinois! – have allowed you to deduct up to $10,000 in contributions ($20,000 for a married couple) from your income as calculated for Illinois income tax. At the present 3% rate, this can amount to a tax savings of up to $300 ($600 for a couple) per year. Understandably, if you chose to transfer those funds to an out-of-state 529 plan, there has always been a recapture provision, requiring you to pay back the tax you saved when you deducted the funds. That used to be the end of the story, but it was too good to be true, as is often the case with tax laws.
With this new change, in effect for tax year 2009, for any withdrawal from your Illinois-based 529 plan that is NOT for qualified education expenses, you are also required to recapture the tax offset. It wasn’t unexpected. If you think about it, the reason the deduction was originally put in place was to incent Illinois residents to set aside money for college. Without this recapture (and the transfer recapture mentioned above) the overall affect of the incentive is disregarded.
All non-qualified withdrawals are subject to taxation on the growth component at the federal and state level, plus a 10% penalty. In the past that was the only consideration you had to take into account with a non-qualified withdrawal. For example, let’s say you had a 529 plan in Illinois with a contribution of $10,000, which had grown to a total of $15,000. When time for college came around, it turned out that your child didn’t want to go to college – she had a good paying job and didn’t plan to further her education. So you decide to withdraw the funds from the 529 account to give her a “head start” on buying a home. The growth component of the account, $5,000, is subject to ordinary income tax on your federal and state returns, plus a 10% penalty. On top of that, you will have to include the original $10,000 contribution on your Illinois return as a part of your Illinois adjusted gross income. So the taxation on your non-qualified withdrawal has the following effects:
Federal tax (25% example) on $5,000 growth = $1,250
Federal Penalty on $5,000 growth = $500
Illinois tax (3%) on $5,000 growth = $150
Recapture tax (3%) on original $10,000 deducted contribution = $300
Total = $1,250 + $500 + $150 + $300 = $2,200 = 14.66% of the non-qualified withdrawal of $15,000
It should be noted that, in the case of the death or disability of the beneficiary-student, the recapture, taxation and penalty do not apply, at the federal or state level.
As I said, this wasn’t unexpected, but it does represent a takeaway of what was a taxpayer-friendly component of the Illinois-based plans. If you have questions on how this might impact you, please let me know.
Photo by Ryan Wick