Avoid these 529 withdrawal traps

Joseph HurleyBy Joseph HurleyBy Savingforcollege.com
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4. Requesting payment be made directly to the college.

Didn't we just suggest that you request your 529 distribution be made directly to the college to ensure proper matching? Then why would we now say this is a mistake?

Requesting the payment directly to the college could be a mistake if you are not sure how thecollege treats the 529 money in its financial-aid process.The correct process is for the college to treat the 529 plan money as a payment of the college's bill. But, colleges often receive checks for outside scholarships won by their students, and they will typically reduce the student's federal, state and institutional need-based grants by an equivalent amount. This is called scholarship displacement.

You would not want the college to view the 529 money the same way it views a scholarship and reduce your child's financial-aid package. Check with the college first and confirm its policy with respect to funds received directly from a 529 plan. You always have the option to request the distribution be made payable to you or your student. It then becomes your responsibility to pay the college.

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.

Read More: Does your state have a 529 tax benefit?

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 529 withdrawal.

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.

6. Failing to coordinate the 529 withdrawal 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.