529 Plans – Withdrawal Traps to Avoid
By Gregg Shaw – February 2015
As we approach the end of the school year and prepare for the excitement of summer, it won’t be long for high school seniors to be heading off to college. Before they even step on campus, the first of many tuition bills will be mailed from the college bursar’s office.
For those parents who were fortunate to save for college using such vehicles like 529 plans, transitioning from the accumulation phase to the withdrawal phase can be a quite confusing. Savingforcollege.com provides several withdrawal traps to avoid.
Taking too much money
Withdrawals from a 529 pan are tax-free to the extent a beneficiary incurs qualified higher education expenses (QHEE) during the year. If you withdrawal more than the QHEE is allowed, the excess is a non-qualified distribution which will be reported as taxable income plus a 10% federal penalty on the earnings portion of the non-qualified distribution. The principal portion is NOT subject to tax or penalty.
QHEE includes tuition, fees, books, supplies, equipment, and the additional expenses of a “special needs” beneficiary. Expenses NOT included as QHEE:
- 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
- A computer, unless the institution requires that students have their own computers
- Transportation costs
- Repayment of student loans
- Room and board costs in excess of the amount the school includes in its “cost of attendance” figures for federal aid purposes. Living off campus? The financial aid department can provide a room and board allowance for students living at home with parents, or living elsewhere off campus. If the student is living in campus-owned dormitories, the amount you can include in QHEE is the amount the school charges for its room and board.
Even if you’ve properly accounted for all qualifying expenses, and withdraw from your 529 account only enough to pay for those expenses, you may still end up with a non-qualified distribution. This happens because of the coordination rules (aka anti-double-dipping rules) surrounding the various education tax incentives. You must remove from your total QHEE any tuition expense that is used to generate an American Opportunity credit or a Lifetime Learning credit. WHEW!!!!
Taking too little money
Unless your student is planning postgraduate education or you have another potential beneficiary in the family to whom you can change the beneficiary designation, generally speaking, it’s not advantageous to have money left over in your 529 account. Used for any other purpose other than qualified college expenses, a 10% penalty will apply for any distribution.
Requesting payment be made directly to the school
Requesting the payment directly to the school “COULD” be a mistake if you are not sure how the school treats 529 money in its financial aid process. Schools often receive checks for outside scholarships won by their students, and they will typically reduce the student’s federal and school-based grants by an equivalent amount.
Check with the school first and confirm its policy with respect to funds received directly from a 529 plan. If needed, you always have the option to request the distribution be made payable to you or your student. It then becomes your responsibility to pay the school.
Taking money from the wrong 529 account
Some parents may have more than one 529 account. Most often this happens when a parent prefers an out-of-state 529 plan over an in-state 529 plan, but does not want to forsake the state tax deduction in those states offering a tax benefit.
Different accounts are going to experience different growth rates. By first tapping the account with the higher earnings ratio once your child gets to college, you are locking in maximum tax savings. If there is money left in a 529 plan after your child graduates, the tax cost associated with non-qualified distributions is minimized because the lowest growth account is left for last.
Multiple accounts are treated separately for tax purposes only when they are in different states. Accounts within a particular state with the same beneficiary must be aggregated for tax purposes.
Failing to coordinate with other family members
Sometimes a child will be the beneficiary of multiple 529 accounts that have different account owners, not just parents, but grandparents and other relatives and friends as well. When it comes times to pay for college expenses, whose account should be used first?
This is a topic that should not be left for the last minute. Family members should be coordinating and discussing how best to use their 529 plan accounts. In some situations, the best solution is for the family members to request ownership be transferred to the parents so that withdrawals can be easily controlled and coordinated.
As always, many financial planning topics such has saving for college can be quite a daunting task to understand. One wrong decision could be a costly mistake. To avoid any financial planning mishaps, most often, it’s always best to call your most trusted financial advisor.