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Avoid these 529 withdrawal traps
5. Taking the money from the wrong 529 account.
Some parents have more than one 529 account. Most often this happens when a parent prefers an out-of-state 529 plan over the in-state 529 plan, but does not want to forsake the state tax deduction in those states offering that particular benefit. Contributions are first made to the in-state 529 plan to take maximum advantage of the state tax benefit, and any remaining money is contributed to the out-of-state 529 plan.
Multiple accounts may also be used when investors wish to diversify or when they see a particularly attractive aggressive option in one 529 plan and an attractive conservative option in another.
Different accounts are going to experience different growth rates. By first tapping the account with the higher earnings ratio once your child gets to college, you are locking in maximum tax savings. If your child graduates when you still have money in 529 plans, the tax cost associated with non-qualified distributions is minimized because the lowest-growth account is left for last.
In a similar way, you may also be locking in a state tax deduction in those states that require a "recapture" of your deduction with non-qualified distributions.
Of course, you will also be concerned about future growth of your 529 money and want to make sure you are not liquidating the account that would be performing best going forward and remain stuck with a low-performing account. Remember, you can adjust your investments through the annual investment change opportunity or through a qualifying rollover.
Multiple accounts are treated separately for tax purposes only when they are in different states. Accounts within a particular state with the same beneficiary must be aggregated for tax purposes.
6. Failing to coordinate with other family members.
Sometimes a child will be the beneficiary of multiple 529 accounts that have different account owners—not just parents, but grandparents and other relatives and friends as well. When it comes time to pay for Junior's college expenses, whose account is used first?
If at all possible, do not leave this question to the last minute. Family members should be speaking to the parents and discussing how best to use their 529 accounts to help pay for Junior's college expenses. In some situations, the best solution is for the family members to request that ownership of their 529 accounts be transferred to the parents so that withdrawals can be easily controlled and coordinated. Not all 529 plans accept requests to change ownership so first check with your plan.
Updated July 20, 2011
Joe Hurley is the founder of SavingforCollege.com, and a certified public accountant.