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Avoid these 529 withdrawal traps

by Joseph Hurley

Your son or daughter has finally graduated from high school and soon will be heading off to college. Before he or she even meets their professors, you will have received the first of many tuition bills from the college bursar's office.

It's a good thing you've been saving for college with a 529 plan. You've got money set aside for just this very occasion. But once you've entered the "withdrawal phase," be sure you make the right decisions when tapping your 529 account. Here are the mistakes you'll want to avoid:

1. Taking too much money.

Withdrawals from a 529 plan are tax-free to the extent your child (or other account beneficiary) incurs qualified higher education expenses (QHEE) during the year. If you withdraw more than the QHEE, the excess is a non-qualified distribution. You or your beneficiary—you get to choose who receives the money—will have to report taxable income and pay a 10% federal penalty tax on the earnings portion of the non-qualified distribution. The principal portion is not subject to tax or penalty.

QHEE includes tuition, fees, books, supplies, equipment, and the additional expenses of a "special needs" beneficiary. For students who are pursuing a degree on at least a half-time basis, QHEE also includes a limited amount of room and board. You CANNOT include the following expenses:

  • Insurance, sports or club activity fees, and many other types of fees that may be charged to your students but are not required as a condition of enrollment
  • A computer, unless the institution requires that students have their own computers.
  • Transportation costs
  • Repayment of student loans
  • Room and board costs in excess of the amount the school includes in its "cost of attendance" figures for federal financial aid purposes. If your student is living off campus, ask the financial aid department for the room and board allowance for students living at home with parents, or living elsewhere off campus, as the case may be. If the student is living in campus-owned dormitories, the amount you can include in QHEE is the amount the school charges for its room and board.

Even if you've properly accounted for all qualifying expenses, and withdraw from your 529 account only enough to pay for those expenses, you may end up with a non-qualified distribution. This happens because of the coordination rules (aka anti-double-dipping rules) surrounding the various education tax incentives. You must remove from your total QHEE any of the tuition expense that is used to generate an American Opportunity tax credit or a Lifetime Learning credit. For example, if you claim a $2,500 American Opportunity credit on a federal tax return you must remove from QHEE the $4,000 in tuition and related expenses that was used to support the credit.

What can you do if you receive a distribution check from your 529 plan only to discover after speaking with your accountant that you've taken too much? If you are still within the 60-day rollover window, you can take the excess and roll it into a different 529 plan so that amount is no longer treated as a distribution, provided you have not rolled over that child's 529 account within the prior 12 months. If you are outside the 60-day window, but within the same calendar year, you can look to prepay next year's expenses to increase this year's QHEE. If you discover the excess withdrawal after year-end, there's not much you can do about it. The good news is that if the non-qualified distribution is caused by the tax-credit adjustment described above, the 10% penalty is waived.

2. Taking too little money.

Generally speaking, you don't want to have money left over in your 529 account once your child graduates from college. Unless your student is planning postgraduate education, or you have another potential beneficiary in the family to whom you can change the beneficiary designation, you'll be left with a 529 account that used for any other purpose will incur tax and 10% penalty. If you have a substantial balance in your 529 account, consider tapping the account at the earliest tax-free opportunity.

You may also want to take withdrawals even when you know that they will result in non-qualified distributions, provided they do not incur the 10% penalty. The penalty is waived on "scholarship withdrawals" and, as described above, when the distribution is non-qualified because of the tax-credit coordination rule. By having the money distributed to the student, the reportable 529 earnings will go on his or her tax return. Not only might your student be in a low tax bracket, but he or she may also be able to wipe out any resulting tax with American Opportunity credit or Lifetime Learning credit. (Because of income limitations, you may not be eligible to claim the credit on your own return.) Unfortunately, the expansion of the "kiddie tax" in 2008 to include college students through the age of 23 may remove the tax-bracket advantage.

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