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529 Plan withdrawals. Costly Mistakes To Avoid

Withdrawing money from a 529 plan should be a simple process. It is not. Done the wrong way it can cost you a significant amount of money in taxes, penalties, and loss of financial aid. You can use 529 plan funds to pay for college, any post-secondary educational institution, and/or up to $10,000 for k-12, tax-free as long as they are used for what is termed Qualified Education Expenses. These expenses include: Tuition, Room, and Board (only if the student is attending at least half-time), books and Supplies, computer, software and internet access, special needs equipment, and up to $10,000 lifetime for student loans. The following are not QEEs: transportation and costs associated, health insurance, college application and testing fees, extracurricular activities. If you use 529 money for these expenses, you will incur taxes and a 10% penalty.

It’s up to the 529 plan account owner to calculate the amount of the tax-free distribution and how they want to receive the funds. If you’re wondering how to withdraw from 529 to pay tuition, you can usually make a withdrawal request on the 529 plan’s website, by telephone or by mail.

What You Need To Know
Don’t wait until the last minute to calculate your 529 withdrawals for the year. You need to give your 529 plan administrator sufficient lead time to process the distribution request in the current calendar year. You must use your 529 money in the calendar year it was distributed to receive the funds tax-free.

When withdrawing from your 529 plan, it’s usually a good idea to lock in your tax benefit by taking the maximum amount from your accounts that will qualify for tax-free treatment. Even if you’d prefer to withdraw less than the maximum amount this year you should still withdraw the maximum amount for tax-free treatment and then you can follow this up by making new contributions to the 529. This way you end up with a higher tax basis in the account and perhaps a state tax deduction.

“Double-dipping” is not permitted when it comes to 529 plans and the education tax credits. If you, or your beneficiary, claim either the American Opportunity Tax Credit or the Lifetime Learning Credit on your federal income tax return, you cannot claim a tax-free distribution of 529 plan money for these same expenses.

The maximum $2,500 American Opportunity Tax Credit accounts for $4,000 of qualified expenses. So, in most cases, this will result in a $4,000 reduction to your 529 expenses.

To be safe, limit your 529-plan withdrawals to your beneficiary’s total qualified higher education expenses less $4,000. If you are not eligible for the American Opportunity Tax Credit but plan on claiming the Lifetime Learning Credit, the adjustment can be for as much as $10,000.

For example, in 2022, Steven incurs $20,000 of qualified higher education expenses including tuition, mandatory fees, room and board, books, supplies, and equipment. His parents have $50,000 in a 529 plan for Steve and withdraw $20,000 during 2022 to reimburse themselves for 100 percent of the qualifying expenses they paid by check. When they file their 2022 income tax returns, Steve's parents claim the $2,500 American Opportunity Tax Credit, which leaves only $16,000 in expenses that can be applied to the 529 withdrawal. The result is a $4,000 non-qualified withdrawal, the earnings portion of which is includable as ordinary income on their income tax return.

Steve’s parents will not incur the 10-percent penalty on the earnings, as the penalty is waived whenever—as in this example—it is caused by the credit adjustment. In some situations, the non-qualified withdrawal will result in no additional federal tax, as the next example shows.

Example 2: Assume the same facts as above, except that Steve’s parents’ make too much money to claim the American Opportunity Tax Credit. It may be a good idea to have Steve claim the tax credit on his return, since he has income from a summer job and will file a return. By making the 529 withdrawal payable to Steve, they ensure that any taxable earnings from the non-qualified withdrawal end up on Steve’s return because he is in a much lower tax-bracket than his parents. In most circumstances, Steve’s American Opportunity Tax Credit will be more than enough to offset any federal taxes, including any tax attributable to the 529 non-qualified withdrawal, and the 10-percent penalty waiver means the non-qualified withdrawal will have no tax consequences.

As you can see from the previous examples, your choice of “distributee” when requesting a withdrawal from your 529 plan can make a significant difference in your family’s combined tax liability.

You will have three options when requesting the withdrawal: 1) having the check made payable to your beneficiary; 2) having the check made payable to the school your beneficiary is attending, or 3) having the check made payable to yourself—the account owner.

Choosing either of the first two options will result in Form 1099-Q being sent to your account beneficiary. In the event any of the withdrawal turns out to be non-qualified, the earnings portion ends up on your beneficiary’s income tax return, where it presumably benefits from lower (or zero) tax rates.

If the entire withdrawal is a qualified withdrawal, it should not matter who receives the Form 1099-Q. The earnings are tax-free and do not get reported on anyone’s tax return.

Requesting payment directly to your college can be a simpler way to handle your 529 distributions, but first, always check the school’s policy around funds received directly from a 529 plan.

The important caveat here is to make sure you understand if, and how, the payment made directly by the 529 plan to the school might affect your child’s financial aid package at that school. Policies can vary at different institutions. They should treat the 529 plan money as a payment of the college’s bill. However, at some schools they will treat it as a “resource” or the same way they treat an outside scholarship and reduce the student’s federal, state, and institutional need-based grants with a dollar-for-dollar reduction in aid. Be sure to ask ahead of time to avoid a nasty surprise.

Under IRS 529 withdrawal rules, qualified room and board expenses for students living off campus can’t exceed the university’s official cost of attendance. You can usually find this info on your school’s website.

The Bottom Line
Your 529 plan is an excellent asset to your children’s college education. However, you must follow the tax and colleges complex rules to maintain your tax-free benefits and financial aid when you decide to withdraw funds for school. That means being aware of qualified and non-qualified expenses, options for leftover funds, and penalties.

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