Much of the advice you hear surrounding 529 accounts stresses the importance of saving in these accounts for tax-advantaged savings toward college costs. But, when it comes time to make withdrawals from the account, there are a few pitfalls you will want to watch in order to avoid unwanted tax issues.
How Much Should I Withdraw?
Any funds taken out will need to be substantiated with qualified education expenses for it to be tax-free. This primarily includes tuition, fees, books, supplies, equipment as well as partial room and board. There is a qualifier for room and board which is that the student needs to be attending at least half-time. Any withdrawals made in addition to these expenses are treated as non-qualified withdrawals and the earnings will be taxed and have a 10% penalty.
If there are earnings in the account, each withdrawal will have a portion that is earnings (original contribution amounts are not taxed or penalized). If you realize you’ve taken too much, similar to IRA’s, there is a 60 day window to roll funds back to another 529 account. You can also plan to prepay next year’s qualified expenses as long as payment is made in same year as withdrawal.
What Happens with Scholarships and Tax Credits?
Because of the tax-incentive you receive when taking the American Opportunity credit or Lifetime Learning credit, you must remove the full cost of tuition and other expenses that enable you to claim the $2,500 Credit. This could shield $4,000 of tuition from not counting as a qualified expense.
If you discover this while doing your taxes, the good news is that the 10% penalty is waived for the portion that becomes a non-qualified distribution. The penalty is also waived in the event that your child receives a scholarship, but taxes will still be due on the earnings.
Who should take the Funds?
Withdrawals can be received by the owner (parent or grandparent), the student, or the school. Earnings on the withdrawals that can’t be substantiated with qualified education expenses will be reportable on the parent/grandparent or student’s tax return. If the student’s tax rate will likely be lower, and you are not sure what the exact cost may be, then withdrawing funds in the student’s name would make the most sense.
If you choose to have funds sent directly to the school, confirm with the school that direct payment will not be viewed as a scholarship and reduce potential financial aid the student could receive. Each school may treat this differently.
Determining how much financial aid a student can qualify for is a complicated formula. If a grandparent (or other family member other than the parent) owns the account, financial aid could be cut by as much as 50%. This is because financial assistance from a third party is counted as student income on the FAFSA application.
An option to prevent this would be to transfer ownership of the 529 to the parent in this situation. Advice from a CFP® can be very beneficial in making decisions when working through these decisions.
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Photo credit: Flickr – Charline Tetiyevsky
