The right way minimizes taxes, avoids penalties, and doesn't jeopardize financial aid.
Year after year, you and your child have been saving for college through a 529 college savings account. Now college is closer and it's time to think about spending the money you've put aside. You'll be in control of how much is withdrawn and how it'll be used, but there are a few things you need to know up front to make the most of your savings.
What can you use this money for? Which expenses trigger taxes and penalties? If you do things right, no penalties or federal income tax—and in many states, no state income tax—will be due on your withdrawals. But learning by trial and error can be costly at tax time, and, more importantly, your child could lose out on financial aid if you're not careful. So learn the ins and outs ahead of time.
Here's a nine-step guide to help you make your 529 college savings go as far as possible.
1. Plan for tax-free withdrawals.
For full details, see IRS Publication 970, Tax Benefits for Education.
Qualified withdrawals are federal income tax free so long as the total withdrawals for the year don't exceed your child's adjusted qualified higher education expenses (QHEE). To calculate these, add up tuition and fees, room and board, books and supplies, and any school-related special needs services, and then deduct any costs already covered by tax-free educational assistance. Examples include Pell grants, tax-free scholarships and fellowships, tuition discounts, the Veteran's Educational Assistance Program, and tax-free employer educational assistance programs. But you're not done yet. You'll also need to deduct costs used to claim American Opportunity or Lifetime Learning tax credits. The basic rule: You can't double up tax benefits for the same college expenses.
2. Know which expenses qualify.
First of all, a 529 account can be used only to pay for expenses that are related to college or other post-secondary training institutions. While funds from a 529 account can be used to pay for expenses required for college, not all expenses qualify. Tuition and fees are considered required expenses and are allowed, but when it comes to room and board, the costs can't exceed the greater of the following two amounts:
1. The allowance for room and board included in the school's cost of attendance for federal financial aid calculations
2. The actual amount charged if the student is living in housing operated by the educational institution
In other words, if your child is planning to live off campus in housing not owned or operated by the college, you can't claim expenses in excess of the school's estimates for room and board for attendance there. So it's important to confirm room and board costs with the school's financial aid office in advance so you know what to expect. Also keep in mind that in order for room and board to qualify, your child must be enrolled half time or more.
Textbooks count as an education expense, but only those included on the required reading for the course. If you think of books as an incidental expense, you'll be surprised to hear that research from the College Board found that students currently spend an average of $1,200 on required books and supplies per year.1
It's important to keep receipts and make sure that essentials are purchased separately from nonessential items. Be careful to avoid expenses that don't qualify—for example, equipment used primarily for amusement or entertainment doesn't qualify. These and other lifestyle expenses, like insurance, sports expenses, health club dues, and travel and transportation costs, will have to be funded through other resources. If you're not sure whether a plan covers a particular college expense, the college's financial aid office should be able to help.
Check with the school to find out exactly what's required so you can avoid accidentally taking a nonqualified distribution. If you withdraw money for anything that doesn't meet the qualified expense criteria, the earnings portion of that distribution will be taxed as ordinary income and could incur a 10% federal penalty. However, the penalty may be waived if there are extenuating circumstances, such as the disability or death of the beneficiary, or if he or she receives a scholarship, veterans' educational assistance, or other nontaxable education payment that isn't a gift or inheritance.
Also keep in mind that state income tax, in many states, may also be due on the amount you withdraw, and your state may impose an additional 10% penalty on earnings for nonqualified withdrawals. In addition, if you were able to deduct contributions on your state tax returns, the state may want to recover the amount you saved.
3. Keep good records.
Your 529 college savings plan administrator will, in most cases, provide an annual statement that reports your contributions and earnings, including the amount you withdrew from the plan. But it's you, not your program provider, who is responsible for accurately reporting to the Internal Revenue Service. You'll have to match your QHEE against your withdrawals on your income tax return. If they're equal or if the QHEE exceeds your withdrawals, all your earnings are tax free. If your withdrawals are higher than your QHEE, you'll have to calculate how much tax is due. For many people, keeping track is easy because large tuition bills use up most of their 529 savings. But if you are using your 529 plan for room and board expenses, it's smart to keep those receipts.
4. Decide how to withdraw the funds.
It's important that withdrawals you take from your 529 college savings account match up with the payment of qualifying expenses in the same tax year. Like some families, you may choose to pay the school directly from your 529 account for ease in recordkeeping and matching distributions to school expenses. In this situation, make sure you are aware of school payment deadlines and the time required to transfer funds from the 529 account to the school. It can take several days for investments to be sold out of your 529 account and mailed to the school.
Or you may choose to move money from your 529 account to your bank or brokerage account. Many colleges prefer payments to be made electronically through their Web site from a bank or brokerage account. You can choose to pay bills first and then reimburse yourself from the 529 account, or you can pull money from the 529 account and then use it to pay bills from your bank or brokerage account. This path also provides flexibility when paying smaller bills like books or off-campus room and board.
Keep in mind that you must submit your request for the cash within the same calendar year—not the same academic year—as you make the payment. If the timing is off, you risk owing tax because it's considered a nonqualified withdrawal.
You'll also want to check with the school first to find out how it treats 529 funds in its financial aid process. You always have the option of requesting that a 529 distribution be made payable to you or your child. But remember, it then becomes your responsibility to pay the school.
If you're enrolled in a plan through a financial adviser, contact him or her when you're ready to withdraw funds. If you have a direct 529 plan, contact the plan administrator for withdrawals. Remember to build in time for processing. Alternatively, you could have the money distributed to your child. In this case, if there are reportable earnings from the 529 account, the earnings will go on his or her tax return. Any earnings are taxed at your child's lower tax bracket—unless the so-called "kiddie tax" applies. The kiddie tax requires certain children as old as 23 to pay tax on unearned income at their parents' marginal tax rate. Check with your tax adviser to see if this applies. Another reason to have the distribution sent to your child is that it may be possible to wipe out any resulting tax with an American Opportunity credit or Lifetime Learning credit, as explained below. Because of income limitations, you may not be eligible to claim these credits on your own return.
Ask your plan provider for instructions if you are interested in distributing money directly to the beneficiary.
5. Plan ahead—529 account funds may conflict with other tax incentives.
The federal government offers additional tax incentives to help ease the burden of some college expenses, but, unfortunately, you won't be able to use a 529 account to cover those same expenses. If you do, the Internal Revenue Service will consider it double dipping, so you'll want to factor in whether you'll be claiming this tax credit when deciding how much to withdraw from your 529 account. These tax credits may also affect your child's eligibility for financial aid.
Below are the two most common tax credits. Remember, a credit goes directly against your tax liability, which is different from a deduction. But only one credit can be claimed for a student each year.
• American Opportunity tax credit allows families of undergraduates to deduct the first $2,000 spent on qualified education expenses and 25% of the next $2,000. To qualify for the full credit in 2014, single parents must have an adjusted gross income of $80,000 or less, or $160,000 or less if married and filing jointly. This credit may be claimed for only four years.
• Lifetime Learning credit provides up to a $2,000 tax credit on the first $10,000 of college expenses so long as your adjusted gross income is $54,000 or less in 2014 for a single filer, or $108,000 if married and filing jointly. There is no limit to the number of years this credit can be claimed.
6. Prioritize which 529 accounts to spend first.
If your child has more than one 529 college savings account, such as an additional account through a grandparent, knowing which account to use first or how to take advantage of them concurrently could help. So don't leave decisions to the last minute. Instead, sit down with all plan owners and decide on a withdrawal strategy ahead of time to make sure the qualifying college costs are divvied up.
For example, you'll want to take advantage of compounding growth. Different accounts experience different rates of growth, so by first tapping the account with the highest return, you may lock in tax savings. Also, different accounts not only experience different rates of growth—they also experience different risks to their investment portfolios. Make sure you consider all risks and the return potential before deciding from which accounts to withdraw. Fortunately, you do have the ability to adjust your investments as you go along.
Also, if financial aid is in the picture, a distribution from a grandparent-owned 529 account may be considered income to the child on the next financial aid application, which could significantly affect aid. You may want to delay the distribution from the grandparent's account until senior year, after the last financial aid form is completed.
7. Money left over in your 529 plan? Make a smart move.
With careful planning, you can avoid having money left over in your 529 account once your child graduates. But if funds remain, there are several options available. You can let the money sit in the account in anticipation of your child's continuing on to graduate school or another post-secondary institution. If so, you'll want to rethink your investment strategy so you can take full advantage of the potential for growth over time.
You also have the ability to change beneficiaries without incurring tax consequences. Here are two different options for maintaining your tax advantage and avoid any penalty.
1. Change the designated beneficiary to another member of the original beneficiary's family. This can be done for any reason, but is an option particularly if your child receives a scholarship or decides not to attend college.
2. Roll over funds from the 529 to one of your other children's 529 plans without penalty. This is a good option if there are funds left over after graduation.
Regardless of which option you choose, you may want to rethink your investment strategy, depending on how soon the funds will be needed.
Also, each state has different restrictions on 529 accounts, so check with your financial adviser or ask your plan provider for the specific requirements of your plan.
Please note—there is a scholarship exception. You can take a nonqualified withdrawal from a 529 account up to the amount of a scholarship, and while you will pay taxes on the earnings, you won't pay the additional 10% penalty that's imposed on a nonqualified withdrawal. Remember to ask for a scholarship receipt for your tax records.
8. Consider how college savings affect student aid and loans.
If, like more than 60% of families,1 you'll count on financial aid to supplement your college savings, you'll want to do what you can to improve your eligibility. While individual colleges may treat assets held in a 529 plan differently, in general they have a relatively small effect on federal financial aid eligibility. Because 529 plan assets are considered assets of the parent, they tend to have a small effect when the government calculates your financial aid eligibility, whereas accounts that are considered assets of the child, such as an UGMA/UTMA account, tend to have a greater effect on federal financial aid eligibility. (This does not affect 529 accounts that are owned by a grandparent.) Seefinancial aid planning for more information.
If you're thinking of taking out loans that start incurring interest immediately, you may want to spend 529 funds first, deferring these loans until later. Another situation that would call for using 529 plan funds first would be if there's a chance your child may graduate earlier or get some other funding down the road, such as a scholarship.
9. Safeguard your plan assets.
Like many investors, you've probably made gains in your 529 plan assets over the last couple of years. But now that you'll actually need to start spending the money you've set aside, it's time to think about preserving those gains —so funds will be there when they're needed. This might be a good time to reduce your overall risk by selling some of your equity holdings and making sure you've set enough aside in more conservative investment options. This way, you won't lose sleep over market conditions. If your plan relies on an age-based investment strategy, this process is already in place and your asset mix has slowly evolved toward more conservative investments like money market funds and short-term bonds.
Next steps
Now's the time to sit down with all the contributing family members and your child and create a withdrawal plan that's ready to set in motion. It's a smart idea to spend from the plan in established increments along the way, and withdraw wisely from your college savings plans, so you can reap the tax advantages and avoid mistakes along the way.