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The best way to withdraw 529 funds
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If your clients' children are heading to college soon, it's time to start considering 529 withdrawal strategies. Here are three important issues you'll want to cover:
1. How much to withdraw
I generally recommend that 529 account owners lock in their tax benefit by taking the maximum amount from their accounts that will qualify for tax-free treatment. If the account owner tells me they would prefer to withdraw less than the maximum amount this year so they can spread the money over the college years, I will suggest they still withdraw the maximum, and follow it up by making new contributions into the 529. This way they end up with a higher tax basis in the account, and perhaps additional state tax deductions.
How much is the maximum tax-free withdrawal? For most parents, it will be 100% of the beneficiary’s qualified higher education expenses paid this year—tuition, fees, books, supplies, equipment, and room and board—less $4,000. The $4,000 is redirected to the American Opportunity Tax Credit (AOTC), which based on a formula is worth up to $2,500 in federal tax savings.
If the account owner neglects to make the $4,000 adjustment and withdraws 529 money equivalent to 100% of eligible expenses, the likely result is a $4,000 non-qualified distribution from the 529 plan. The earnings portion of the non-qualified distribution will be reportable as ordinary income, but the 10 percent penalty on earnings is waived.
Of course, if income phase-outs prevent the taxpayer from claiming the AOTC, the $4,000 adjustment need not be made. Another reason for NOT making the $4,000 adjustment is where doing so will lead to a leftover balance in the 529 plan once college is completed. Better to pay the tax now with no penalty, than to pay it in the future plus a 10 percent penalty.
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