529 Plans Redux

Each year on May 29 the calendar reminds us of the 529 educational savings plan, and opportunities to fund the plan.  However, many people funded 529 plans years ago and are now ready to withdraw the funds for their intended use. Distributed properly, all the earnings in the plan can be income tax free as long as the funds are used for Qualified Higher Education Expenses (QHEE).  However, as is sometimes the case, the devil is in the procedural details.

It would be nice if just keeping good records of educational expenditures was sufficient to take full advantage of the income tax benefits. It isn’t. There is an extra degree of care necessary to avoid the pitfalls which could result in unnecessary income tax and penalties. Here are a few missteps you’ll wish to avoid.

Taking Out Too Much Money

Matching up your withdrawals from the account with the QHEE for each calendar year is very important. Taking out more than the QHEE amount can result in some of the earnings portion of the withdrawal being taxed at your ordinary income tax rate, and the possible assessment of a 10% tax penalty.

Not Accounting For Education Tax Incentives

Any amount that was used to create American Opportunity or Lifetime Learning tax credits cannot be counted as QHEE. The amount of these credits can be as high as $2,500 and could cause the equivalent disallowance of otherwise QHEE-eligible tuition payments.

Taking Money in The Wrong Year

Withdrawals must match up with payments in a given year. If you make a December withdrawal and pay for tuition in January, the January payment cannot count as QHEE. This would trigger income tax and a penalty.

Requesting Payment to Be Made Directly To The School

Determine how the school treats 529 funds 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. Confirm how the school counts the 529 money so that it doesn’t have the unintended effect of reducing your student’s financial aid package.

Recordkeeping and Reporting

• Tracking of cost basis is done by the program manager and will flow thru to a 1099-Q in the year of distribution.
• The 1099-Q will go to the distributee.
• As long as QHEE is higher than distributions on 1099-Q in a year, then you are done. If the distribution is higher than the QHEE then you report the excess amount as “other income” on your return.
• The owner of the 529 should keep all bills, invoices and receipts in order to document all eligible expenses.
• Be prepared to share your records should the IRS select your tax return for examination and request documentation.

In Conclusion

As with most financial planning opportunities afforded by government programs there is no shortage of nuances and pitfalls. 529 plans are no exception. Please engage your advisor as you plan for your children or grandchildren so we can assist you in deriving maximum benefit from your strategy.