How to Withdraw from a 529 Savings Plan

This post was written by Robert at The College Investor. As well as personal finance and investing, The College Investor has great resources on student loan forgiveness and student aid.

If you are reading this, you have been amazing parents/grandparents/etc…!!! Why? Because you have been contributing to your child’s 529 College Savings Plan. You probably already know why you invested in this plan to start with, and all the great savings advantages, but now comes the tricky part – how to withdraw money from this plan without getting hit by the tax man!

What is a 529 Savings Plan?

A 529 College Savings Plan is a tax-advantaged savings plan designed to encourage savings for future college expenses. The main idea of this plan is that the account holder (usually a parent or guardian) establishes an account with a beneficiary (the future student) for the purpose of paying the beneficiary’s eligible college expenses. An account holder can invest the funds in the account in stocks, bonds, mutual funds, or money market funds. This account can then be used to cover “qualified education expenses” such as tuition, room and board, mandatory fees, and required books. Many plans have contribution limits in excess of $200,000. What is great about these plans is that the earnings in them are not subject to federal taxes, and in most cases state taxes, as long as the rules below are followed.

The Pitfalls of “Qualified” and How To Withdraw the Smart Way

Withdrawals from a 529 plan are tax-free to the extent that the beneficiary (your child) incurs qualified higher education expenses during the year. So, the first big pitfall is withdrawing too much money. If you withdraw too much money, the excess is considered a non-qualified distribution. At this point, either you or your child will have to report the income and pay a 10% federal tax penalty. Only the gains are taxed, however, not the original principal.

Here are some expenses you may consider qualified, but the government does not:

• Insurance, activity fees, sports fees, etc….
• Computers.
• Transportation costs.
• Repayment of student loans.
• Room and board in excess of what the school includes in its “cost of attendance” figures for federal financial aid purposes (can’t put your child in a fancy place if the going rate at the school is half of that).

Also, to be qualified, you must take the amount less any tax credits. So, if you qualify for the Lifetime Learning Credit of $2,000, your qualified education expenses must subtract this amount.

What can you do if you discover that you have withdrawn too much money? Well, if you are within a 60-day window of withdraw, you can roll-over the excess amount into another 529 plan, and that amount will not be treated as a distribution.

Withdrawing Too Little

You don’t want to withdraw too little either, because you don’t want to have money left over once your child has finished school. If there is money left over, you can use the money for the child’s graduate education (if they are going that route), or you can designate another beneficiary (maybe a younger sibling?).

If there is still money left over, you may consider withdrawing it for the child anyway. You will incur the penalty, but the child may be in such a low tax bracket that it is more of an advantage for them to withdraw than the parent.

Withdrawing in the Wrong Year

While this may seem obvious, it can be difficult depending on your child’s education institution. A 529 Plan follows the calendar year, and any withdraws must match up year to year. The trouble involves institutions that bill tuition at the end of December, and you don’t get the bill until January. Here, the qualified expense will take place in December of Year 1, but the withdraw would take place in January Year 2. If you withdraw in Year 2, you run the risk of over-withdrawing that year’s qualified expenses (see risk #1).

The IRS is currently considering a rule that will be similar to IRA contributions (where you have until April 15 to contribute for the prior year), but that hasn’t occurred yet.

Requesting Payments Be Made to the School

If you request payments be made to the school, make sure that you understand how the school will treat this payment. Schools receive lots of payments, and they sometimes process these payments as grants or aid. You want to make sure that your child’s 529 payment does not reduce the child’s potential federal student aid or any grants or scholarships won.

You want to make it clear that 529 money is the same as the parent writing a check, and not like a scholarship or grant. You always have the option to request the distribution be made payable to you or your child. That way, the financial aid office cannot tinker with any other aid received.

A 529 Plan is a great way to invest in a child’s education. The tax breaks are generous, that the plans are very flexible. It is essential, however, to make sure that distributions are done correctly. Failing to do so could result in a hefty unexpected tax bill.

Do you or anyone you know currently invest in a 529 plan for their child? Do they have any concerns relating to taking money out?