Timing of 529 Plan Distributions Must Match Qualified Expenses
The longer you save for college in a 529 plan, the more time the funds have to grow on a tax-deferred basis. But, eventually, most parents have to take a distribution to pay for college. To make the most of your college savings, it’s important to pay attention to the timing of 529 plan distributions. Distributions must be taken in the same tax year in which the qualifying expenses are paid.
529 plans do not have 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.
The 529 plan account owner, not 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
- Use the funds to further their own education
- Save the funds for a future grandchild
- Take a non-qualified distribution and pay ordinary income tax and a 10% penalty on the earnings portion of the distribution
- Do nothing
However, the rules are different with Coverdell Education Savings Accounts (ESAs) and prepaid tuition plans.
Families who use a Coverdell ESA to save for college are required to withdraw funds within 30 days after the beneficiary turns 30 years old, unless the beneficiary has special needs. The earnings portion of any unspent funds after the beneficiary turns 30 years old are subject to a 10% penalty. Money in a Coverdell ESA must also be withdrawn within 30 days if the beneficiary dies.
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.
Matching distributions with qualified expenses
529 plan distributions must be made during the same tax year that the qualified expenses are incurred. 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 up with qualified expenses.
This intended to prevent potential abuse where 529 plan account owners let their funds grow tax-deferred for an extended period of time before taking a distribution to pay for previous expenses. The longer funds are held 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 bill. 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 that will be made 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 make a prepayment for 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 amount of the distribution used to pay tuition should match the tuition reported on Form 1098-T, which 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, 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. If a student is prepaying college tuition, the form 1098-T that they receive from the college should include the total amount of tuition costs being paid upfront. The family should confirm with the college that this will occur.
The American Opportunity Tax Credit (AOTC) and 529 plan distributions
Eligible parents may claim a $2,500 annual federal tax credit based on $4,000 in qualified college expenses such as tuition, fees and required textbooks. Qualified expenses for the AOTC include those paid during the current tax year, or within three months of the next tax year.
Parents may take a 529 plan distribution during the same year that they claim the AOTC, as long as there is no double-dipping. It is recommended to allocate $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.
A good place to start