Timing of 529 Plan Withdrawals

Eventually, parents with a 529 plan will want to take a distribution to pay for college. When they do, they need to know they must take all withdrawals from college savings plans in the same tax year in which they pay the qualifying expenses, or they could incur a penalty and be taxed on the withdrawal.

Timing of 529 Plan Withdrawals Must Match Expenses

You must make 529 plan distributions during the same tax year that you incur the qualified higher education expenses. This is not an official IRS rule, but it is implied by published IRS guidance. Tax professionals and other experts agree that 529 plan distributions should match qualified expenses.

This is intended to prevent potential abuse where 529 plan account owners let their plan funds grow tax-deferred for an extended period before taking a distribution to pay for expenses incurred in a previous calendar year. The longer you hold funds in a 529 plan account, the greater the financial benefit.

Families should pay attention to spring semester tuition bills. Spring semester typically begins in January, but colleges might send the bill in December (of the previous tax year). If a family receives a spring semester tuition bill in December, they may take a qualified 529 plan distribution in December to pay the tuition expenses. If they wait until January (the next tax year) to pay the tuition, they should wait until January to withdraw funds from their 529 plan.

Unlike the American Opportunity Tax Credit (AOTC), taxpayers cannot anticipate qualified 529 plan expenses they will make at the beginning of the next tax year. The Internal Revenue Code of 1986 has an explicit exception for the AOTC at 26 USC 25A(g)(4) that allows one to prepay expenses for an academic period that begins during the first three months of the next tax year. There is no similar statutory language for 529 plans.

Taxpayers receive a Form 1099-Q from their 529 plan that lists distributions in a given tax year. The distribution amount used to pay tuition should match the tuition reported on Form 1098-T they receive from the college. Form 1098-T includes tuition and related fees but does not include other qualified 529 plan expenses, such as room and board expenses, computers and internet access, or K-12 tuition. If a 529 plan account owner accidentally takes a distribution during the wrong tax year, they may roll the funds into the same or another 529 plan within 60 days to avoid taxes and penalties.

College Tuition Prepayment Options

Some private colleges allow students to prepay for upcoming academic terms at a fixed or discounted price. Families may take a qualified 529 plan distribution to pay for a prepayment plan of a qualified school. If a student is prepaying college tuition, the college should include the total tuition costs paid upfront in the 1098-T they receive. The family should confirm with the college that this will occur.

Federal Tax Credits and 529 Plan Distributions

Eligible parents may claim a $2,500 annual American Opportunity Tax Credit (AOTC)  credit on their tax return based on $4,000 in qualified college expenses such as tuition, fees, and required textbooks. Qualified expenses include those paid during the current tax year or within three months of the next tax year.

The Lifetime Learning Credit also factors into these calculations, with tax credits up to $2,000 available. You cannot claim the Lifetime Learning Credit if you claim the AOTC. Parents may take a 529 plan distribution during the same year they claim the tax credits as long as there is no double-dipping on tax benefits. That is, you must subtract the amount of any expenses used to justify the American Opportunity Tax Credit or Lifetime Learning Tax Credit, as outlined in IRS Publication 970. Tax professionals generally recommend claiming $4,000 in tuition and textbook expenses for the AOTC before taking a 529 plan distribution for the remaining expenses since the AOTC is worth more per dollar than the tax savings from a 529 plan distribution.

529 College Savings Plan Withdrawal Deadlines

529 plans do not have specific withdrawal deadlines. A 529 plan account owner is not required to take a distribution when the beneficiary reaches a certain age or within a specified number of years after high school graduation, and funds can remain in the 529 plan account indefinitely. This is a massive benefit over other tax-deferred accounts.

The 529 plan account owner, not necessarily the beneficiary, retains control of the assets throughout the life of the account. If the beneficiary decides not to go to college, or there are leftover funds in the account, the 529 plan account owner may:

• Change the beneficiary to a qualifying family member
• Save the funds to pay for the beneficiary’s graduate school or a future grandchild
• Roll over the funds tax-free to a Roth IRA for the beneficiary
• Use the funds to further their education
• Take a non-qualified distribution and pay ordinary federal income tax and a 10% penalty on the earnings portion of the distribution.
• Do nothing and let the funds grow.

However, the rules differ between Coverdell Education Savings Accounts (ESAs) and prepaid tuition plans.

Withdrawal Deadlines for a Coverdell ESA

Families who use a Coverdell ESA to save for college must withdraw funds within 30 days after the beneficiary turns 30 unless the beneficiary has unique needs. The earnings portion of any unspent funds after the beneficiary turns 30 years old is subject to a 10% penalty. If the beneficiary dies, money in a Coverdell ESA must be withdrawn within 30 days.

Withdrawal Deadlines for a Prepaid Tuition Plan

Most prepaid tuition plans require the prepaid tuition plan to be used starting within 10 or 15 years after expected matriculation in college or by age 30. Some prepaid tuition plans have additional deadlines. Some prepaid tuition plans exclude time spent in active duty military service from the deadlines.

How to Make a 529 Plan Withdrawal

Taking money out of your 529 plan can seem pretty straightforward, but it can be tricky if you don’t do it correctly. Not only is the timing right, but you must also budget out what expenses are being paid for and ensure you don’t withdraw too much money.

You can learn more about withdrawing money from your 529 plan, but here are the four main steps you need to follow:

• Step 1: Calculate how much you are spending on qualified education expenses.
• Step 2: Determine when to withdraw the funds.
• Step 3: Decide which 529 plan account to withdraw from, if applicable.
• Step 4: Complete a withdrawal request online with the plan administrator.

It’s essential to get this right, or you might end up paying a penalty and be taxed for the withdrawal at the beneficiary’s typical tax rate.

The Bottom Line

Withdrawing the money accumulated in a 529 plan can be rewarding as you prepare to cover college costs. However, you need to make sure that you go about it the right way, including the timing of your withdrawal. If you don’t withdraw the funds during the same tax year that you incur the expenses, you can incur a penalty and end up paying taxes on those non-qualified withdrawals.