Avoid these errors when tapping 529 plans for college bills
Avoid these errors when tapping 529 plans for college bills Foster’s Daily Democrat
August is back to school month, and for parents with kids in college, it is also time to write a rather hefty check for tuition.
According to the most recent Sallie Mae study, How America Pays for College 2019, the average amount families paid for college for the 2018-2019 school year was $26,226, most of which was funded via parent income and savings. More than one-fifth of families used a 529 College Savings Plan to cover some of the expense. Assuming these parents started the plans when their kids were young, they will have received a significant boost in the investment earnings on this savings since these earnings grow tax-deferred and are only ultimately taxed if the money is not used for qualified education expenses. The funds can be used tax-free for college costs, and the Tax Cut and Jobs Act expanded the definition of qualified education expenses to include up to $10,000 annually for elementary or high school tuition.
529 Plans are great vehicles to save for future education costs, but it is important to know the related IRS rules that govern withdrawals from these plans so that the tax benefits are not lost. The most important rule to know is that withdrawals from 529 plans are tax-free up to the amount of qualified higher education expenses incurred by the account beneficiary. Taking out more than this amount triggers a “non-qualified distribution” which will result in the earnings portion of the excess being subject to ordinary income tax plus a 10% penalty. This income is reported by the taxpayer who received the distribution, either the parent or the student depending upon to whom the account owner (usually the parent) had the withdrawal paid. Note that, since these plans are funded with after-tax dollars, the amount of each withdrawal that represents the original investment in the plan is always paid tax and penalty-free.
Qualified higher-education expenses include tuition, fees, books, supplies, computers and peripherals, and additional expenses incurred by a student with special needs. Room and board also counts for students who are pursuing a degree on at least a half-time basis. However, for students living off-campus, room and board only qualifies up to the amount the college includes in its published “cost of attendance.” Things like insurance, activity fees, transportation, dorm room or apartment furnishings, and student loan repayments cannot be paid for via tax-free 529 plan withdrawals.
Keeping track of these costs is the key to avoiding a tax hit on any withdrawals. The college will provide a Form 1098-T reporting payments it received for tuition and fees at tax time which will help with the recordkeeping, but it will not likely reflect all qualifying expenses. Be sure to keep track of amounts paid for books, computers and other items that will not show up on Form 1098-T or bills from the university. Also, be sure to account for other college-related tax-benefits you may be eligible to claim on your tax return, as these can trigger a non-qualified 529 plan withdrawal just the same as simply taking too much out of the plan relative to the annual expenses.
If you will claim the American Opportunity Credit on your tax return, for instance, you will have to reduce the qualified expenses used to offset the 529 plan withdrawals by the $4,000 applied to the tax credit. You cannot use the same expenses for both the tax credit and tax-free withdrawals from a 529, but the 10% penalty does not apply when qualified expenses must be reduced to account for the credit.
Fortunately, there is a small do-over window if you determine that you withdrew too much from a 529 in a given tax year or took money out for non-qualified expenses by mistake (such as paying back student loans thinking that would qualify). 529 plans have a 60-day rollover rule like IRAs. An excess withdrawal that is deposited into another 529 plan for the same child beneficiary within 60 days of the distribution will be treated as if it never happened for tax purposes, as long as another rollover for the same beneficiary was not completed within the prior 12 months. Note that this rollover deposit must go into a new 529 plan for the same beneficiary. It cannot go back into the account from which it was withdrawn.