529 Plan Owners Beware – Use your funds wisely or pay the price
By Joe Messinger, CFP®
February 18, 2015
Many families recognize the value of 529 savings plans. 529 plans provide an easy way to put aside money for college that will earn interest tax-free (when used for qualified college expenses). Plus by setting up direct deposits, parents can create a deposit schedule for their plan and pretty much forget about it. However, when the time comes to make withdrawals from that plan, questions can arise.
When should you withdraw the 529 funds?
There is no federal limit or restriction on the number of times you can withdraw funds from a 529 in a given year. The 529 plan itself may have restrictions on how many times you can access funds in a year, but this would not impact taxation of withdrawals. However, you must take withdrawals in the same calendar year that the qualified expenses were paid. It doesn’t matter if funds are withdrawn in January for expenses that are not paid until August, or if the withdrawal occurs in December for expenses previously paid during that year. Just make sure they match up within the same calendar (tax) year.
We have heard rumblings that the IRS is considering new rules that would offer more flexibility across the calendar year divide, but nothing has been finalized so I wouldn’t hold my breath.
How much should you withdraw from your 529 plan?
I generally recommend that 529 account owners take the maximum amount from their accounts that will qualify for tax-free treatment (see below) and lock in the benefit. If the account owner tells me they would prefer to withdraw less than the maximum amount this year so they can spread the money over the college years, I will suggest they still withdraw the maximum, and follow it up by making new contributions into the 529.
A special note for families that choose an in-state 529 plan: Many states offer a state income tax deduction if you choose a 529 plan offered by the state of your residence. For example, if you are an Ohio resident and you fund the Ohio Tuition Trust Authority 529 (College Advantage), you receive a state income tax deduction on the first $2,000 you contribute to the plan. This is an easy way to save $100 each year on your state tax return even while the kids are in college. Since 4 years of college is typically spread over 5 tax years, this simple strategy could save you $500!
How much can you withdraw tax-free from your 529 plan?
For most parents, it will be 100% of their student’s qualified higher education expenses paid this year—tuition, fees, books, supplies, equipment, and room and board—less $4,000. In order to take advantage of the American Opportunity Tax Credit (AOTC), the family must assume the first $4,000 of qualified expenses themselves. By paying the first $4,000 in expenses themselves, families can receive up to $2,500 in federal tax credit. Not deducting the $4,000 is considered “Double Dipping”.
If the account owner neglects to make the $4,000 adjustment and withdraws 529 money equivalent to 100% of eligible expenses, the likely result is a $4,000 non-qualified distribution from the 529 plan. The earnings portion (or interest the 529 earned on your contributions) of the $4,000 will be reportable as ordinary income, but the 10 percent penalty on earnings is waived.
Some families are not eligible for the AOTC because of their higher income. If income phase-outs prevent the taxpayer from claiming the AOTC, the $4,000 adjustment need not be made. Another reason for NOT making the $4,000 adjustment is where doing so will lead to a leftover balance in the 529 plan once college is completed. If you don’t have another student to transfer the remaining 529 funds to, better to pay the tax now with no penalty, than to pay it in the future plus a 10 percent penalty.
As you can tell, withdrawing funds from your 529 plan is not a “one size fits all”. Work with your tax professional and your other trusted advisors to determine your best strategy and carefully weigh your options. If we can help, let us know!