Saving for College with 529 Plans
With kids heading off to college this month and next, many parents are ready to pull funds out of college savings accounts to pay for that first year of college. For those with 529 Plans, it may seem simple, but there are some timing and tax planning issues to consider.
529 Plans have been a popular choice for years, and a recent study estimated that 25% of the monies held for college are locked up in these plans. Earnings and capital appreciation in a 529 Plan have not been taxed, and if the funds are withdrawn properly there won’t be any income taxes paid at that point either. But if the funds are not withdrawn properly, there can be some fairly large tax consequences.
Generally speaking, you can withdraw funds tax-free for qualifying expenses such as tuition, fees, supplies and equipment. You can even cover a portion of room and board so long as the student is attending school more than half time. But, the mechanics are important, so here’s a quick guide to how to make tax-free withdrawals.
How Much Can Be Withdrawn?
In many instances, you cannot simply withdraw the total cost of tuition. If you’re claiming one of several tax credits, you won’t be able to withdraw the full amount. For example, let’s say your child’s tuition is $20,000 and you’ve been blessed to qualify for a $2,500 American Opportunity credit. Since this tax credit is based on the first $4,000 of your child’s tuition, you have to exclude that amount from the amount you withdraw from the 529 Plan. You can only withdraw $16,000 to avoid a tax bill. Anything beyond that would be taxed as regular income.
In a similar vein, scholarship money restricts the amount you can withdraw from the 529 Plan. This one’s a bit easier since the formula is a straight forward 100%. If your child receives a $2,500 scholarship, then you have to subtract that amount from the total tuition bill.
Who Should Receive the Withdrawal Amount?
Withdrawals from a 529 Plan can go to the account owner (typically the parent), the student or the school, but there are different potential tax consequences to each. Checks made payable directly to the account owner bear no potential penalty. However, the IRS may ask for proof that the funds were used for qualified expenses, so keep very accurate records of what you do with the money.
Checks made payable to the student are likewise free from penalty, but the same record keeping requirements are imposed. One benefit of this option, though, is that if some of the money is used for non-qualifying expenses, then the tax bill would be calculated at the student’s tax rate – typically much less than mom’s and dad’s.
Checks made payable directly to the school provides the easiest record keeping, but there are some risks here. Many schools will adjust the amount of financial aid a student has been awarded if they see money coming from a 529 Plan. 529 Plans owned by parents are not counted in the federal student aid formula, but schools can set their own rules. If they get a check directly from a 529 Plan, they could reduce aid they’ve awarded.
529 Plans owned by a grandparent or other non-direct family member are a bit trickier. This would be considered a third-party disbursement and would be included in the federal student aid formula as student income. If your student qualifies for need-based aid, it may make sense to have grandma and grandpa transfer the 529 Plan to mom and dad before withdrawals are made.
When Should Withdrawals Be Made?
Timing is everything. To avoid tax penalties, you need to withdraw money in the same calendar year as you pay the qualifying expenses. Seems easy enough – in July when the bill for the first semester arrives – but what about in December when the second semester bill may arrive? If you withdraw funds in December in order to pay for qualifying expense which you will actually incur in January of the next year, technically you haven’t matched withdrawals and qualifying expenses. This type of advance payment can result in a tax liability for the amount of the December withdrawal.
All Things Considered, Are 529 Plans Still A Good Idea?
Simple answer here: Yes! Back in the old days when these plans were first introduced, investment options were limited and fees were high. We weren’t big fans of 529 Plans then. With the passing of time and lots of competitive pressure, 529 Plans have become a very effective, and reasonably priced, college savings mechanism. If you pay attention to the details (and a qualified investment professional can help), you’ll still be well ahead of the tax man and have lowered your total college costs to boot.