While you may have received little or no tax benefit of saving for your children’s college education through the years, when made correctly, distributions from 529 plans will be free from tax. Nevertheless, there are several things to bear in mind to avoid any surprises at tax time as you begin doling out a small fortune to the college of your choice. Here are some things to remember.
Use all of your 529 distributions to pay for education
It sounds simple enough – use all of your 529 withdrawals to pay qualified higher education expenses in a given tax year and you will incur no tax liability or penalties on your distributions. If, however, your distribution is more than your education costs, the excess is considered a non-qualified distribution, the earnings portion of which is subject to tax and a 10% penalty. 529 distributions are reported on Form 1099-Q which shows the breakdown between your earnings and your basis (the amount you contributed to the plan).
In general, qualified higher education expenses include tuition, fees, books, supplies, computers and related equipment as well as expenses of a special needs beneficiary. A limited amount of room and board also qualifies as long as the student is pursuing a degree on at least a half-time basis.
The following expenses do not qualify:
- Insurance, sports or club activity fees, and many other types of fees that may be charged to your students but are not required as a condition of enrollment.
- Transportation costs.
- Student loan repayments.
- Room and board in excess of the room and board allowance for federal financial aid purposes that applies to students living at home with parents, or living elsewhere off campus. If the student lives on campus, the amount the school charges for its room and board qualifies.
Make sure not to double dip
Despite your efforts to match your 529 withdrawals with your qualified expenses, you may still have a non-qualified distribution if you take advantage of any tax incentives offered by the American Opportunity Tax Credit (AOTC) or Lifetime Learning Credit (LLC); or any tax-free scholarships, fellowship grants, employer assistance or the like. Any tuition expenses used for tax credits and any tax-free educational assistance received must be removed from your qualified expenses for distribution purposes. For example, you withdrew $9,000 to pay tuition and fees and received an AOTC of $2,400 on your return. The maximum amount of qualified tuition for AOTC purposes is $4,000, leaving you with $5,000 of qualified expenses for distributions. To prevent double dipping, the earnings portion of the $4,000 will be subject to tax since you used it for the AOTC, but you catch a break in that the 10% penalty is waived.
If you discover you withdrew too much, you are allowed a 60-day window to roll any excess distribution into a different 529 plan (provided you haven’t done so within the prior 12 months) so that it is no longer treated as a distribution (like a rollover). If that is no longer an option, but you are within the same calendar year, you can prepay next year’s expenses to increase this year’s qualified expenses. If you discover the excess withdrawal after year-end, there’s not much you can do about it. The key is to match your qualified costs and distributions as closely as possible within a given calendar year to avoid any taxation and penalties.
Beware of distributions made directly to the college
While this is a good way to match distributions with college costs, before requesting that payments be made directly to the student’s school, inquire as to how it handles 529 funds in its financial aid process. Schools will typically reduce the student’s federal and school-based grants for outside scholarships awarded to their students. Make sure that they do not treat direct 529 payments the same way. Failure to do so could result in a reduction in your student’s financial-aid package.
Coordinate your 529 distributions with other family member plans
It is not uncommon for a student to be the beneficiary of not only their parents’ 529 accounts, but of those owned by their grandparents, godparents, other relatives and even family friends. There should be open discussions with all parties involved as to how to best to use their 529 accounts. One alternative is for ownership in all of the 529 accounts to be transferred to the parents in order to coordinate distributions. Check with all of the plans to verify that this is an option.
Use it or lose a piece of it
While it is next to impossible to match saving for your children’s higher education dollar for dollar with its actual future cost, the objective is to spend down the 529 fund to as close to zero as possible, unless your student is planning postgraduate education, or you have another student on the horizon to whom you can change the beneficiary designation. Remember, any 529 funds that are used for any other purpose will be subject to tax and the 10% penalty. After all, Uncle Sam allows your fund to grow tax free as long as it is used for higher education. Despite your best efforts, if you expect to have a sizable balance in your 529 account after all education is paid for, there are a couple of things you can do.
First, consider taking withdrawals that, even though they are non-qualified, are not subject to the 10% penalty. This would include scholarship withdrawals and any tuition excluded due to the tax credits described above.
Secondly, have the distribution made to the student. This will make the 529 earnings reportable on his or her tax return, presumably at a lower tax bracket than yours. Moreover, any resulting tax may be minimized by the AOTC or LLC as long as the student may claim the personal exemption for him or herself. Such tax credits may not be available to the parents due to income phase outs.
If you have questions, please contact Victor C. Belgiorno at 516-861-3704 or .