5 tips for a tax-free 529 plan withdrawal
Saving for college with a 529 plan is easy. Once you set up your account, you decide when you want to contribute and how much. Most plans even allow automatic deposits from your checking account. But things can get tricky once it’s time to withdraw funds to pay for college. A non-qualified withdrawal could mean having to pay income tax as well as a 10% penalty on the earnings portion of the distribution. These five tips will walk you through the withdrawal process and help you maximize the value of your college savings.
1. Calculate your qualified expenses
529 plans offer tax-free growth and tax-free withdrawals, but only when the funds are used to pay for qualified higher education expenses. For college students, this includes tuition, fees, books, supplies, room and board (if the student is enrolled at least half time), computers and internet access and expenses for special needs beneficiaries. It does not include costs of transportation or health insurance unless the college charges them as part of a comprehensive tuition fee, or the fee is identified as a fee that is “required for enrollment or attendance” at the college. Up to $10,000 per beneficiary can also be withdrawn tax-free to pay for tuition at elementary and secondary schools. Under the SECURE Act of 2019, 529 plans can be used to repay student loans and pay for registered apprenticeship programs.
After you add up your total qualified expenses, subtract any amount that was used to generate an American Opportunity tax credit (AOTC) or Lifetime Learning credit. These are federal tax incentives offered to families paying for college. With the AOTC, parents who qualify can claim a tax credit for 100% of the first $2,000 spent on college expenses for a dependent child, and up to 25% of the next $2,000, for a $2,500 total tax credit. However, the expenses used to support the credit ($4,000 maximum) cannot be included in 529 plan qualified expenses – there is no double-dipping.
2. Decide which account to use
Your child may have more than one 529 plan account. Parents sometimes contribute to an in-state 529 plan just enough to claim a state tax deduction, and then deposit the rest of their savings into another plan. If this is the case, consider withdrawing from the account with the highest growth rate first. This can help minimize the tax implications if you end up taking a non-qualified distribution in the future.
It’s also common for grandparents and other relatives to have accounts separate from the child’s parents. Be sure to discuss how much will be withdrawn from each account before taking a distribution. If the total amount of the withdrawals exceeds the amount of the beneficiary’s qualified expenses, someone could wind up with a non-qualified withdrawal.
It’s also important to consider financial aid implications. Distributions from a 529 plan owned by a parent or dependent student will not affect financial aid eligibility, but if the account is owned by a grandparent or other relative the amount withdrawn will count as student income on the Free Application for Federal Student Aid (FAFSA). This can reduce the student’s aid package by as much as 50% of the distribution amount. To minimize the impact, wait to withdraw funds from grandparent-owned 529 plans until January 1 of the student’s sophomore year of college (assuming they will graduate in four years). Since income from two years prior must be reported on the FAFSA, there will be no subsequent year’s application to be affected by the distribution.
3. Match distributions to qualified education expenses
529 plan distributions should be taken during the same calendar year the qualified expenses were paid. Many parents pay tuition with cash or a credit card, and then reimburse themselves with the student’s 529 plan. But if you withdraw the 529 plan funds first, before the tuition bill is due, pay attention to the calendar. For example, when paying the college’s spring tuition bill in December 2020, the distribution must be taken and used to pay the spring tuition bill in 2020 for it to count as a 2020 expense.
4. Make the distribution payable to the beneficiary
With most 529 plans, you have the choice of making your distribution payable to the account owner, the beneficiary or the college or other institution they are attending. Requesting payments be made to the beneficiary, and then using the money to pay the college is usually the simplest option. This way, the Form 1099Q will have the beneficiary’s social security number, and if any part of the withdrawal ends up being non-qualified it will be taxed at their (presumably) lower tax bracket.
5. Evaluate any leftover funds
What if there is remaining money in the 529 plan account after you’ve paid for all of your child’s qualifying expenses? You have a couple of options. You can save the money for your child to attend graduate school or change the beneficiary to another qualifying family member who will be going to college (including yourself). If your child used any tax-free scholarships to pay for college, you can take a non-qualified withdrawal up to the amount of the award without incurring a penalty (you will still have to pay income tax on the earnings portion). Or, you can consider leaving the money in the account for a future grandchild.
A good place to start