Withdrawing funds from a 529 plan may seem simple enough, but once you have entered the “withdrawal phase”, you need a plan of action before you pay that first tuition bill. Knowing the key steps and tax-planning issues to watch out for are essential to maximize the effectiveness of your 529 plan.
Here are the key steps to withdraw funds from a 529 plan:
1) Review the terms, conditions, and procedures of your specific 529 plan.
The first thing you will want to do is make sure you understand the specifics of your 529 plan. Do not assume all 529 plans work the same way.
2) Contact the school your child will be attending.
Inquire what the school’s administrative system is for utilizing 529 plans and make sure you are aware of payment deadlines. It is also important to research the school’s financial aid policies since payments for tuition from 529 plans can affect how much financial aid the child qualifies for. Do this every year as the regulations may change.
3) Know what you are working with and prioritize which 529 account to withdraw from first.
Find out exactly how many 529 plans there are for this particular beneficiary and coordinate a distribution schedule. This will help with any overpayments and confusion. Make sure all involved are on the same plan and communicate as the funds are redeemed. If financial aid is a factor, a distribution from a grandparent-owned 529 account may be considered income to the child on the next financial aid application. You may not want to use this 529 plan until senior year, after the last financial aid form is completed.
4) Know what expenses are considered “qualified”.
If you withdraw money for anything that does not meet the qualified expense criteria, the earnings portion of that distribution will be taxed as ordinary income and you could incur a 10% federal penalty.
The following expenses are considered to be “qualified”: tuition, mandatory fees, required books, supplies and equipment for college use specifically. For college students who carry at least half the normal workload according to standards used by the college to determine full-time status, payments for room and board can be considered qualified education expenses.
Note: The penalty may be waived if there are extenuating circumstances, such as the disability or death of the beneficiary.
5) Coordinate your withdrawals with education tax credits.
The two tax credits available to help offset the cost of higher education by reducing the amount of your income tax are the American Opportunity Tax Credit and the Lifetime Learning Credit.
If you, or your beneficiary, claim an education tax credit on your federal income tax return, you must adjust the total qualified higher education expenses (QHEE) of your 529 plan distributions. The basic rule is that you are not able to double up tax benefits for the same college expenses. Qualified withdrawals are federal income tax free as long as the total withdrawal amount for the year does not exceed your child’s adjusted qualified higher education expense.
If you claim the maximum $2,500 American Opportunity credit on your federal tax return, you will need to remove from your QHEE the $4,000 in tuition and related expenses that was used to support the credit.
The Lifetime Learning Credit provides a tax credit of up to $2,000 per taxpayer for education expenses. The amount of the credit is equal to 20% of the first $10,000 of qualified tuition and related expenses paid by the taxpayer. It is available on a per-taxpayer (family) basis, which means that if you have multiple children in school at the same time and your tuition bills total more than $10,000, you will only get the credit for the first $10,000 paid.
6) Decide the method of redeeming the 529 plan funds.
You have several options on how the funds from the 529 plan are redeemed.
- Request a check or online deposit to be sent to the student.
- Request a check or online deposit to be sent to the account owner.
- Request a check or online payment to be sent directly to the university.
If you have the check made payable to the student, the tax Form 1099-Q reporting the distribution to the IRS will reflect the student’s name and Social Security number. This could be an advantage if there are reportable earnings from the 529 account, the earnings will go on his or her tax return. Any earnings are taxed at your child’s lower tax bracket.
If you have the distribution sent directly to the university, the payment transfer is easier since you do not have to handle the funds yourself. A disadvantage of using this method is that some schools will adjust the student’s financial aid when they receive a payment directly from a 529 plan. Be sure to contact the school before hand to inquire what their financial aid policies are.
Be familiar with the required time it takes to distribute the funds as well as the time required to transfer funds from the 529 account to the school. It can take several days for investments to clear banks and be available for use.
7) Match up distributions & expenses in the same calendar year.
A distribution can be taken at any time during the year and must match up with the payment of qualified expenses in that same year. If you take a distribution at the end of the year that is not paid until January, you risk not having enough QHEE during the year of withdrawal.
Your 529 college savings plan administrator should provide an annual statement that reports your contributions and earnings, including the amount you withdrew from the plan. If you are not provided this information, contact the plan administrator to request it to be able to accurately report the transactions to the Internal Revenue Service. Be sure to keep receipts of payments for your records.
Carol Chaudet
(Last updated 08/16/2016)