Know the Rules Before Making 529 Plan Withdrawals

529 Plans are great vehicles for saving for college. But it's important to know the rules before making any withdrawals.

Congratulations. Your son or daughter has been accepted to college, and now you get to pay (some of) the bill. That’s a lot easier if you’ve been stashing away money in a tax-free 529 College Savings Plan, but make sure you handle the 529 Plan withdrawals properly to avoid taxes, penalties, and headaches.

What Are Qualified Education Expenses?

One of the first things you need to do is get familiar with the terms “Qualified Educational Expenses (QEE)” and “Qualified Higher Education Expenses (QHEE).” These are the IRS guidelines for spending your 529 Plan savings on legitimate expenses.

Qualified education expenses are the amounts you pay for tuition, fees, and additional related expenses for eligible students, at eligible educational institutions. Tuition payments must be for a degree program or other recognized academic credit at the college level.

In addition to tuition, qualified expenses include room and board, books and supplies, computers and related equipment, as well as money used to repay student loans (capped at a $10,000 maximum lifetime limit per student). However, all of these come with exceptions.

529 Plan Withdrawal Rules

According to the IRS, withdrawals from 529 Plans are tax-free “when used for qualified education expenses of the designated beneficiary,” as described above.

Qualified withdrawals cannot exceed your child’s QHEE’s. To get that number, add up all the eligible expenses and subtract any costs covered by tax-free assistance, such as scholarships, fellowships, Veteran’s benefits, Pell Grants, and the American Opportunity Tax Credit (AOTC).

Also, in 2017, Congress expanded the 529 Plan program to include up to $10,000 for K-through-12 private school tuition, as well as apprenticeships at Labor Department approved programs. Read more about how your 529 Plan can help your grade school kids.

What Does Not Qualify?

Remember those exceptions? Well, you can’t put your kid into the penthouse suite at the Four Seasons. Qualified room and board expenses are limited to the equivalent charged to live in school-sponsored housing, even if your child lives off-campus.

The cost for books is limited to those deemed required reading for a course. That’s still a hefty sum. The College Board found the average cost for required reading and supplies in the 2019-20 school year was $1,240.

Computers generally qualify, but not software for games or hobbies. Smartphones do not qualify.

Transportation and travel costs, insurance, sports activities (unless required), and health club memberships are not covered.

Suppose you use the money for non-qualified expenses. In that case, the portion of your withdrawals that are considered account earnings are taxed as ordinary income and may be subject to an IRS 10 percent penalty.

Keep Track of Two Calendars  

One significant confusion arises because the IRS works on a calendar year that does not coincide with the academic year. Avoid withdrawing funds from the 529 Plan in one year to pay for expenses due the following year. Doing it wrong makes it a non-qualifying event, subject to taxes.

For instance, you might decide in December to take out the money you need for the Spring semester, which is due in January. That’s where you run into problems with the two calendars. You should delay your withdrawal until early January. On the other hand, if your tuition is due in December, don’t wait until the week after Christmas to request the money. It can take a week or more to process your request.

How to Withdraw 529 Plan Funds

There are several ways to withdraw money from your 529 Plan. You can have a check made out to the account beneficiary (the student), you (as the account owner), or paid directly to the college or university. If you know the exact amount for tuition, the third option may be the easiest and least complicated.

The IRS Knows All

In any year you withdraw money from a 529 Plan, you will receive a tax document from the 529 Plan provider (Form 1099-Q). That means you cannot sneak one by on your tax filing. If some or all of the amounts withdrawn are taxable, you will have to report it on your 1040. It’s also worth noting that if the 529 Plan check is made out to the beneficiary (the student), they will receive the tax form.

If withdrawals exceed your Adjusted Qualified Education Expenses, you could be subject to a tax hit. For full details about your tax obligation, speak with your accountant, or check out the official IRS website to read about Publication 970, Tax Benefits for Education.

Consult with your financial planner to ensure you cross all your T’s and dot your I’s. In addition, the school receiving the money can help you do things right, but it’s up to the account holder to calculate what qualifies as tax-exempt and what does not.

You Can’t Double Dip

As mentioned above, you need to subtract the amount you receive for an American Opportunity Tax Credit, Lifetime Learning Credit, or a Pell Grant. Even if you use withdrawals only to pay for qualified expenses, you could end up with a non-qualified distribution for double-dipping.

What Happens to Unused 529 Plan Funds?

If you are lucky enough to have any money left over after your child graduates, you have several options. You may use up to $10,000 of the funds to pay off additional student loans, such as graduate school. You can also change the beneficiary to another child or a grandchild. Finally, you can choose to liquidate the account if you’re willing to pay the tax and 10% penalty. Remember that the tax is only on the gains, not the principal you invested. The penalty may be waived in certain circumstances, such as if the beneficiary receives a tax-free scholarship or attends a U.S. Military Academy.

What Else Should I Know about Making 529 Plan Withdrawals?

  • Each parent can contribute up to $16,000 per year into a 529 plan or $32,000 for a married couple. The same is true for grandparents. Anything above those amounts would be considered a taxable gift and require filing a gift tax return. Interestingly, however, a legitimate strategy allows you to “superfund” your contribution by putting in five years’ worth of money at one time. That’s $80,000 per person or $160,000 per couple.
  • The rules pertaining to accounts set up by grandparents are similar to what we’ve outlined, but there are a few differences to be aware of. A potential trap could impact financial aid calculations when grandparents set up 529 Plans, but effective October 1, 2022, a new FAFSA form eliminates that issue.
  • There are a few exceptions to note when setting up 529 Plans. The biggest one is that not all states give tax breaks, and those that do sometimes only do so for their own 529 Plans. For instance, New Jersey does not allow you to take deductions for a Nevada 529 Plan.
  • State tax treatment of 529 Plan distributions may differ from Federal tax treatment. It is important to consider the State tax rules when taking a distribution to ensure you comply with both Federal and State tax law. Record-keeping is critical. Carefully track receipts, withdrawal dates, and payment dates in case you get audited.

The bottom line is that 529 Plans are a great way to save for college in a very tax-efficient way, but you need to be aware of all the rules before making 529 Plan withdrawals. It’s a situation where learning by trial and error can be costly.

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