5 things advisors need to know about 529 withdrawals

http://www.savingforcollege.com/articles/5-things-advisors-need-to-know-about-529-withdrawals-1046

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529 plans are, for many investors, reaching maturity. As parents and grandparents increasingly draw down on these accounts to pay for college, they are increasingly seeking the counsel of financial professionals on how and when they should be taking distributions. Sometimes the questions might seem straightforward, but there are some nuances to 529 plans that can result in headaches if you don't do a little homework ahead of time.

1. Contact the plan well in advance of a withdrawal request

True story: Advisor X contacted their client's plan provider to request that a check be disbursed to the account owner. However, the advisor was only recently assigned the account due to the departure of their predecessor. As a result, the advisor needed to go back to the client and have them complete the requisite paperwork – which also required a signature guarantee – in order to be assigned to the account.

Once the advisor was been assigned to the account, they were able to request the disbursement. Unfortunately, they still needed to update their client's address, which had changed. The address change then placed a temporary hold on the account as an anti-fraud measure to allow sufficient time to notify the account owner of the change. This all led to delays for the client, and headaches for both parties.

There are other events that can trigger a temporary hold on the account, as well. Some plans will restrict withdrawals shortly after a deposit is made as an anti-laundering provision. Changes related to any bank information associated with the account can result in a temporary freeze lasting over two weeks.

So to change addresses and get everything sorted can take several weeks when information is out of date. Be proactive and make sure that the account information is updated and current as the beneficiary approaches college age. Contact the plan and familiarize yourself with their withdrawal process, as each plan has its own unique rules and policies.

Related: Avoid these 529 withdrawal traps

2. Find out how long it will take

"What do you mean five to 10 days? The bill is due tomorrow."

Investors are fickle, and rare is the client that takes care of things in advance. Even if you've contacted the plan in advance to make sure all the account information is up to date, it can still take time to disburse a check. Your client – or more likely you as the advisor – may not be happy to eat the cost of an overnight mail charge in order to get the money to the account owner or school quickly.

Tuition, rent and similar bills are all something that can be planned for. Unfortunately, the account owner and beneficiary do not always plan well. So when the beneficiary forgets to tell their parent that they need to make their rent payment or they'll lose their lease – and oh yeah, that's tomorrow – it's good to know exactly how long it will take to deliver, and what those options are.

Every plan works a little differently, and some plans may have restrictions regarding how withdrawals work depending on whether the assets in the account need to be liquidated before disbursement. The amount of time it takes to settle trades varies between plans, but most plans will give themselves at least a three-day window to process a distribution request. Prepaid and similar plans may have their own unique rules. But once the assets within the account are in cash, most – but not all – 529 savings plans will allow:

• A standard or overnight check to be mailed without cost to the account owner, beneficiary or school of record
• Wire transfer

Some broker-dealers are now able to process most transactions within their own trading system, depending on the plan. This varies by firm, though, so check with your product support department if you're unsure of your system's capabilities.

Certain plans administered by Ascensus College Savings are now capable of making payments directly to certain schools. Check with your plan provider to see if this might be an option for your client.

Related: The best way to withdraw 529 funds

3. Know where the check is going

You need to know if the plan allows disbursements to the beneficiary, third-parties (such as their landlord), or directly to the school. Some plans do not allow direct distributions to the school without first receiving instruction from the client in writing. Other plans do not allow distributions to the beneficiary or to third-parties.

Also, adding addresses can trigger a temporary account freeze as an anti-fraud provision, as mentioned earlier. So knowing where the check is going can also avoid unpleasant delays.

On a separate but important note, the Form 1099-Q will be sent to the individual that receives the distribution. If the check goes to the account owner, it will go under their social security number. If it is distributed to the beneficiary, it will be under their social security number instead (assuming the account owner and beneficiary are not the same person). While it doesn't matter who the check is sent to so long as there are qualified higher education expenses associated with the withdrawal, the IRS has a history of sending additional tax and penalty forms – erroneously – to the account owner. So it can be a good idea to send the check directly to the beneficiary, assuming they're trustworthy, because they are less likely to then be required to substantiate the claim.

Plus, if some portion of the withdrawal to the beneficiary ends up being non-qualified, it would then be assessed at the beneficiary's tax bracket rather than the account owner's. Usually, this means a lower bracket.

Related: How to pay your tuition bill with a 529 plan

4. Time the withdrawals carefully

For many families withdrawals will be requested to pay bills in the fall and spring, aligning with the respective semesters at the school. The important thing is to take the 529 withdrawal in the same calendar year in which the qualified expenses are paid. So if the account owner takes their withdrawal in December, they will want to make sure they actually pay for qualified higher education expenses in December. If the account owner fails to pay the bill until January, they may miss out on qualified expenses for the preceding calendar year, and could further put themselves at risk for a non-qualified withdrawal the following year.

That said, there is no clear guidance from the IRS about the timing of penalty-free withdrawals for scholarships. Because scholarships are not always something you can predict or time, and can result in leftover funds in the 529 account, it is a common question as to whether the account owner is allowed to make their penalty-free withdrawal in the calendar year(s) following the receipt of a scholarship or scholarships. Most experts agree that these special situation withdrawals do not need to match up to the calendar year. Just be sure to closely track all scholarships when requesting a distribution in the respective amount, and remember that the withdrawal will still include a portion of earnings that will be taxed at the rate of the recipient (just not penalized).

5. How much to withdraw

Account owners should usually withdraw the total amount of qualified expenses they've incurred during the year. There is never a guarantee that the beneficiary will finish college, or finish college on-time. A recent report from nonprofit group Complete College America found that only 19% of full-time students at public universities earn a bachelor's degree in four years. So it's usually better to lock in the tax benefit early.

There are a couple reasons your client may want to delay withdrawals. If the account owner is a grandparent or other third-party, and the beneficiary will be applying for federal financial aid, it might be worth back-loading the withdrawals. Third-party withdrawals will count as student income on the FAFSA for the tax year in which the respective expense is paid. For example, a grandparent with $100,000 in the account might wait until the beneficiary's junior year to make disbursements. Taking a disbursement in the first or second year may impact their qualification for aid in the third and fourth year, and then there is no money in the account to make up for the gap.

Lastly, if the account owner plans to claim the American Opportunity Tax Credit, then they will want to subtract $4,000 from their total qualified higher education expenses for the year before taking a 529 plan withdrawal. This is due to the "anti-double dipping rule," which prevents account owners from taking advantage of two federal tax benefits on the same college savings assets. For 2016-17, the account owner only qualifies if their modified adjusted gross income is $90,000 ($180,000 for joint filers) or less, and only for the full amount of the credit if their modified adjusted gross income is $80,000 or less ($160,000 or less for married filing jointly).

Related: Ask an expert: Can I use 529 plan funds to pay for college and get the American Opportunity Tax Credit?