Saving for college with a 529 plan is easy. Once you set up your account, you decide when you want to contribute and how much. Most plans even allow automatic deposits from your checking account. But things can get tricky once it’s time to take a 529 plan withdrawal to pay for college.
If you take a non-qualified withdrawal, you’ll miss out on tax benefits and may have to pay a penalty. These five tips will walk you through the withdrawal process and help you maximize the value of your college savings.
1. Calculate your qualified expenses
529 plans offer tax-free growth and tax-free withdrawals, but only when the funds are used to pay for qualified higher education expenses. For college students, this includes tuition, fees, books, supplies, room and board (if the student is enrolled at least half time), computers and internet access and expenses for special needs beneficiaries. It does not include costs of transportation or health insurance unless the college charges them as part of a comprehensive tuition fee, or the fee is identified as a fee that is “required for enrollment or attendance” at the college. Up to $10,000 per beneficiary can also be withdrawn tax-free to pay for tuition at elementary and secondary schools. Under the SECURE Act of 2019, 529 plans can be used to repay student loans and pay for registered apprenticeship programs.
After you add up your total qualified expenses, subtract any amount that was used to generate an American Opportunity tax credit (AOTC) or Lifetime Learning credit. These are federal tax incentives offered to families paying for college. With the AOTC, parents who qualify can claim a tax credit for 100% of the first $2,000 spent on college expenses for a dependent child, and up to 25% of the next $2,000, for a $2,500 total tax credit. However, you cannot include expenses used to support the credit in your 529 plan qualified expenses. The IRS does not allow taxpayers to double-dip tax benefits.
2. Decide which account to use
Your child may have more than one 529 plan account. Parents sometimes contribute to an in-state 529 plan just enough to claim a state tax deduction, and then deposit the rest of their savings into another plan. If this is the case, consider withdrawing from the account with the highest growth rate first. This can help minimize the tax implications if you end up taking a non-qualified 529 plan withdrawal in the future.
It’s also common for grandparents and other relatives to have accounts separate from the child’s parents. Be sure to discuss how much they will withdraw from each account before taking a distribution. If the total amount of the withdrawals exceeds the amount of the beneficiary’s qualified expenses, someone could wind up with a non-qualified 529 plan withdrawal.
It’s also important to consider financial aid implications. Distributions from a 529 plan owned by a parent or dependent student will not affect financial aid eligibility. However, if the account is owned by a grandparent or other relative you have to report the amount withdrawn as student income on the Free Application for Federal Student Aid (FAFSA). This can reduce the student’s aid package by as much as 50% of the distribution amount.
To minimize the impact, wait to withdraw funds from grandparent-owned 529 plans until January 1 of the student’s sophomore year of college (assuming they will graduate in four years). Since you report income from two years prior on the FAFSA, the distribution will not affect a subsequent year’s application.
3. Match your 529 plan withdrawal to qualified education expenses
You should take 529 plan distributions during the same calendar year that you pay for the qualified expenses. Many parents pay tuition with cash or a credit card, and then reimburse themselves with the student’s 529 plan. But if you withdraw the 529 plan funds first, before the tuition bill is due, pay attention to the calendar. For example, you must take the distribution and pay your tuition bill in 2021 for it to count as a 2021 expense.
4. Make the distribution payable to the beneficiary
You generally have the choice of making your distribution payable to the account owner, the beneficiary or the college. Directing the payment to the beneficiary and then using the money to pay the college is usually the simplest option. If the Form 1099Q has the beneficiary’s social security number, any non-qualified withdrawals are taxed at their lower tax bracket.
5. Evaluate any leftover funds
What if there is remaining money in the 529 plan account after you’ve paid for all of your child’s qualifying expenses? You have a couple of options. You can save the money for your child to attend graduate school or change the beneficiary to another family member.
If your child used any tax-free scholarships to pay for college, you can take a non-qualified withdrawal up to the amount of the award without incurring a penalty (you will still have to pay income tax on the earnings portion). Or, you can consider leaving the money in the account for a future grandchild.