The January Question

http://www.savingforcollege.com/articles/the-january-question-708

Financial Professional Content

At the beginning of each year, Savingforcollege.com receives the same question. We call it "The January Question," but it should really be addressed before year-end, because waiting until January may yield an unfortunate answer to this question:

"We set up a 529 plan for our child. He/she started college last fall and we paid the college bills out of our own funds. Can we now reimburse ourselves out of his/her 529 plan without be subject to taxes or penalty?"

The unfortunate answer to this is “no,” though it is possible another tax professional would offer a different opinion. This interpretation of the IRS guidelines is based on longstanding tax accounting principles for cash-basis taxpayers. Most individuals use the cash basis form of accounting. This means 529 plan distributions must match up with qualifying college payments within the same tax year, meaning the calendar year.

In other words, count all qualifying expenses paid during the calendar year and – before December 31 of that year – take distributions from the 529 plan in an amount up to, but not more than, the total expenses. The account owner may also need to make a downward adjustment of total expenses for amounts used to claim the American Opportunity Tax Credit or Lifetime Learning Credit.

Unfortunately, the concepts of "school year" and "tax year" can become easily confused. It is especially important to properly time the payment of second semester tuition bills since students often have the option of paying the bill in December or in January.

Note that ours is a conservative interpretation. The IRS has not point-blank stated that 529 distributions can only be matched-up with qualified expenses paid in the same calendar year, but approached the issue when publishing Announcement 2008-17 back in January 2008 which stated, in part:

"Section 529 is silent regarding whether distributions must be made from a section 529 account in the same tax year as QHEEs (qualified higher education expenses) were paid or incurred. Concerns have been raised that individuals could allow the account to grow indefinitely on a tax-deferred basis before requesting reimbursement or use distributions in earlier years to pay QHEEs in later years."

The announcement goes on to say the IRS expects to develop a new rule permitting recipients of 529 plan distributions to count only those qualifying expenses paid during the same calendar year as the distribution, plus expenses paid within the first three months of the following year. But that rule still has yet to be implemented.

Also, occasionally the account owner fails to take maximum distributions, and ends up with leftover 529 funds because the beneficiary graduated in a prior year. If the account owner is intent on withdrawing the balance, and not leaving it in the plan for the use for other family members, the best alternative is to look back and add up the tax-free scholarships awarded to the student during his/her college career. These amounts are eligible for a waiver from the 10 percent additional tax on the associated earnings portion of the non-qualified distribution. Instead of income exclusion, you end up with income deferral.

The good news is that within any single calendar year the timing of distributions does not affect taxability and the proceeds of the distribution do not have to be traceable to a particular expenditure. So even if the account owner fails to make the requested reimbursement within the same calendar year, they can still use that withdrawal against future expenses in the upcoming year. Then, as year-end approaches, be sure to revisit the topic and make those withdrawals before year-end. Or, if the school allows it, make the spring tuition payment in January so that the account owner has more breathing room to make the respective withdrawal request.

Originally posted 2015-01-07