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.
2. When to withdraw it
Take withdrawals in the same calendar year that the qualified expenses were paid. It doesn’t matter if funds are withdrawn in January for expenses that are not paid until August. Or if the withdrawal occurs in December for expenses previously paid during that year. Just make sure they match up within the same calendar year.
The IRS is considering new rules that would offer a little additional flexibility across the calendar year divide, but thus far has not finalized those proposals.
Towards year-end, 529 account owners should sit down and figure out exactly how much was spent on qualified expenses during the year and make the appropriate “catch-up” distribution from the 529 plan. As part of this process, determine if the AOTC is maximized by paying second semester college bills in December versus January.
Just don’t wait until the last day of the year to go through this exercise. The 529 plan administrator must be given sufficient lead time to process the distribution request in the current calendar year.