Dear Joe, I established a 529 plan for my son a few years back and he is now a freshman in college. I paid the fall semester tuition bill from my own funds, and now I want to get reimbursed by the 529 plan. I am wondering about the best way to do this. Should I have the distribution made payable to me or to my son? Does this need to be done before the end of the year? How should I handle future semesters? Thanks very much. -- George
You generally have three options when requesting a distribution from a 529 plan: 1) a check made payable to the account owner, 2) a check made payable to the student or 3) a payment made directly from the 529 plan to the student's college. I prefer the second option in almost all cases. Your child can then simply endorse the check from the 529 plan over to you.
The advantage with having the check made payable to the student is that the Form 1099-Q reporting the distribution to the IRS shows the student's name and Social Security number. If the student incurs qualifying higher education expenses, or QHEE, during the calendar year that are equal to, or greater than, the gross distribution figure on Form 1099-Q, the distribution is tax-free. And when all 529 plan distributions in a year are tax-free, nothing is shown on the student's Form 1040. The IRS can always "audit" the return, but in the vast majority of cases will simply assume the 529 earnings were properly excluded.
If the check from the 529 plan is made payable to the account owner, the process is different even if the end result is the same. This time, Form 1099-Q is issued with the account owner's name and Social Security number. In addition, a box on the Form 1099-Q is checked, indicating that the "distributee" is someone other than the beneficiary. Even if the distribution is entirely tax-free, that is the account beneficiary incurred sufficient qualified expenses during the year, the IRS is likely to issue a notice to the account owner when it sees nothing reported on his or her Form 1040. The account owner now has to respond to the IRS and justify the exclusion of earnings. Why submit yourself to this time-consuming and anxiety-filled process when it can easily be avoided?
Another reason for preferring the second option concerns situations where the earnings portion of the distribution is fully or partially taxable because the beneficiary has insufficient qualified educational expenses. This can occur, for example, because the beneficiary received a scholarship and the account owner made a decision to pull unneeded funds from the 529 plan. It's important to note that taxable distributions avoid the usual 10 percent penalty to the extent the beneficiary received scholarship monies. By making sure the distribution is reported to the beneficiary, the earnings are taxed at the student's tax bracket, which is typically much lower than the account owner's bracket unless the so-called "kiddie tax" applies. The kiddie tax requires certain children as old as 23 to pay tax on unearned income at their parents' tax brackets.
What about the third option: directing the 529 plan to make payment directly to the school? The reason to be wary of this option is that some schools receiving a payment directly from a 529 plan will treat it in much the same way that outside scholarships are treated. If the student is awarded a needs-based financial aid package, the school can adjust that award downward on a dollar-for-dollar basis. Be sure you ask about the policies at your child's particular school beforehand.