Poor 529 planning opens door to taxes


Dear Joe,

I paid my son's tuition for his spring 2008 semester of college from my checking account in December 2007. I didn't submit the 529 distribution request until April 2008. Then I read the 529 plan's fine print. Have I created an unqualified withdrawal by not making the withdrawal in the same calendar year as I paid the tuition (even though it was only a few months later)?

-- Rebecca

Dear Joe,

Can you withdraw funds from a 529 in 2008 for payment of next semester's bill, which starts in 2009, without penalties being applied?

-- Cheryl

Dear Rebecca and Cheryl,

Your inquiries raise the same question: For withdrawals from a 529 plan to be tax- and penalty-free, must they be taken during the same calendar year in which the college expenses are paid?

Rebecca, you are concerned about a withdrawal taken in April of this year for the expenses you paid in the prior year. Cheryl, you are wondering about taking a withdrawal this year in anticipation of next year's payment of college expenses.

Unfortunately, both of these scenarios involve some risk of tax and penalty because of the mistiming of withdrawals and payments.

However, the consequences of these actions are not certain. Nothing in Section 529 of the federal tax law specifically requires the matching of withdrawals and expenses within the same calendar year. However, general tax accounting principles may demand it. Ultimately, it's up to you and your professional tax adviser to decide the appropriate reporting of distributions when preparing your income tax returns.

The Internal Revenue Service has acknowledged the uncertainty taxpayers using 529 plans face. In its Announcement 2008-17, issued in January 2008, the IRS includes the following statement:

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.

As we await final clarification from the IRS, I strongly urge anyone taking money from a 529 account (assuming the account has grown in value) to match the withdrawals and the payment of qualified expenses within the same calendar year. This becomes especially important as we close in on the end of the year and schools begin sending out bills for the second semester. In many cases, you have the option of paying the bill in either December or January.

Rebecca, even though you intended your 2008 withdrawal to be a reimbursement of 2007 expenses, you will still avoid any problems to the extent that your son incurs additional college expenses in 2008. However, you should avoid taking excess withdrawals from your 529 plan this year.

Cheryl, you should wait until 2009 before withdrawing 529 funds for 2009 expenses. Although the IRS wants to provide a three-month window to help parents like you, that rule is not yet in effect. If you've already withdrawn the funds from your 529 plan this year, pay the associated college bills before Dec. 31.

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