You might think that when using 529 plans to save for higher education expenses, the hard part is opening and funding the account, and then deciding how to invest the money while it’s there.
But tapping the account has its own potential opportunities and pitfalls, especially if you’re not aware of the ins and outs of taking the money out.
Here is what you and your clients need to know about using 529 funds for higher education (and other) expenses:
The Key Word: “Qualifying”
Withdrawals from 529 plans are exempt from taxation as long as the proceeds are used for qualifying expenses incurred by a student at a qualifying institution.
To be eligible, the student must be enrolled in a qualified institution. This generally includes almost all two- and four-year institutions in the U.S., as well as several international schools. You can check if a particular school is eligible by visiting savingforcollege.com/eligible_institutions.
Qualifying expenses include tuition, books, fees and mandatory supplies and materials. If the student is enrolled at least half-time in a qualified institution, room and board can also meet the criteria, subject to the figure determined by the school’s financial aid department.
If the withdrawals can’t be matched with qualifying expenses, the earnings portion of the
withdrawal may be subject to federal, state and local taxation, along with a 10 percent penalty.
Taxes May Not Be an Issue
The use of funds in a 529 plan is only a concern if the account value at the time of the withdrawal exceeds the amount contributed. If not, the money can be withdrawn at any time with no taxes or penalties and used for any purpose. Some states may impose a penalty if the owners received a state income tax break when the deposits were made.
If the account is completely liquidated, the loss may qualify as a miscellaneous itemized deduction on Schedule A of the account owner’s 1040 tax form.
Right Away, or Wait?
Parents of college freshmen will be tempted to use 529 plan proceeds to pay the first expenses incurred until the account is exhausted, worrying about the effects years later.
But that could be short-sighted, especially if in the future the family needs the funds for a more urgent purpose, or student loans become more costly and difficult to obtain than they are when the student first enrolls in school.
The family may be better off using a portion of the account value each year, especially if the student qualifies for lower-interest subsidized loans that can help offset any deficits.
However, your clients and their children should know that using 529 plan proceeds to pay education loans doesn’t meet the criteria of “qualified higher-education expenses.”
Maximize Tax Savings
Another reason to take just a portion of the account out each year is that it may help the family qualify for additional tax savings.
Under the American Opportunity Tax Credit, for example, taxpayers can deduct 100 percent of the first $2,000 and 25 percent of the next $2,000 spent on qualifying education expenses from their tax bill.
But that money can’t come from a tax-qualified distribution from a 529 plan. So the best way to benefit from both the credit and the distribution is to pay the first $4,000 of annual expenses from a checking or savings account, and then take the remaining amount needed from the 529 plan.
Education tax breaks are generally available only to those with income below certain limits. Check out Publication 970 at www.irs.gov for more information.
Cutting the Check
Funds must be requested from and issued by the 529 plan sponsor in the calendar year in which the expenses are incurred. The money can usually be issued to the account owners, the student beneficiary, or directly to the institution. Each potential recipient has a potential drawback.
If the funds go to the owners (usually the parents), the 529 plan will issue a 1099-Q to the owners, as well as to the IRS. The IRS then may subject the owners to the hassle of proving that there are qualifying expenses to match to the distribution.
Sending the money directly to the student may be a better idea, as long as she is reliable enough to spend the funds paying for qualified expenses—rather than, say, a spring-break vacation.
Both of these issues can be avoided by having the money sent directly to the school. But clients may then have trouble tracking and verifying the payment, especially since it would likely take place when the school’s financial personnel are swamped.
Too Much Money?
For reasons good or bad, sometimes there is a surplus left in a 529 account after the beneficiary’s academic experience has ended. The owners of the account are left with several options. Most plans don’t have a mandatory distribution age, so the funds can be left alone in case the beneficiary decides to go back to school some day.
The account’s surplus can also be transferred tax-free to one with a new beneficiary, as long as he is a family member of the current beneficiary.
Of course, the funds can be withdrawn and used by the owners, with the understanding that they may owe taxes and penalties on the earnings portion of the account.
But if the owners want to save on taxes and help the beneficiary, they may want to first transfer the ownership of the account to her. Then she can withdraw the money, and will likely be in a lower tax bracket than the owners/parents.
She will still owe a penalty on the earnings portion of the withdrawal. But if she is gainfully employed, she can use the money to make a contribution to a pre-tax retirement savings plan such a 401(k) or IRA, potentially offsetting the tax liability.
