A 529 plan can be a great way to save for college, giving you tax-free investment growth and withdrawals for qualified expenses, but getting your money out when those tuition bills start rolling in can be tricky. Pros say there’s a right way — and definitely a few wrong ways — to take money out of a 529 account if you want to avoid a surprise tax bill.
Watch the calendar
You can take money out of a 529 at any time during the year, but in general your withdrawals need to be less than or equal to the college expenses you actually paid during the year. So, if you’ve got a tuition bill to pay next January, don’t make a withdrawal for it from your 529 in December — it’ll be in the wrong tax year, warns Barbara Weltman, author of “J.K. Lasser’s 1001 Deductions and Tax Breaks 2017.”
If you withdraw too much during the year, the IRS could smack you with a 10% penalty plus income taxes on some or all of the excess (there are exceptions; chapter 8 of IRS Publication 970 has all the details).
Remember to count financial aid
Avoid making needless withdrawals by accounting for tax-free financial aid, such as scholarships, grants or GI Bill money. They reduce the amount of your qualified higher education expenses. If you forgot about those sources and realize you took out too much from your 529, think about using the excess to prepay tuition or buy a new computer for Junior, says Brad Dillon, a vice president in private wealth management at Brown Brothers Harriman in New York. That could help avoid taxes or a penalty.
See if Uncle Sam will foot some of the bill
Pay for everything from your 529 plan, and you could be leaving money on the table. That’s because tax credits and deductions earmarked for education expenses could reduce what you take out of your 529.
The American Opportunity Credit, for example, could lighten your tax bill by up to $2,500 a year if the expenses that got you the credit weren’t paid for with money from a 529.
So if you plan to take the American Opportunity Credit (go here to see if you qualify), you might want to pay just enough of your tuition bill out of a regular savings or checking account or other source of cash to get the credit, Dillon says.
“That way you can still take the tax credit, and then all of the remaining expenses come from the 529 plan,” he explains. (See the sidebar for other education tax breaks that might come into play.)
Coordinate with Grandma
If several members of the family have each set up a 529 account for Junior, be sure to communicate with them to avoid withdrawing too much or too little, Weltman says. Also, take a look at how each account is performing.
“Maybe leave the high performer alone and take it from the lower performer,” she says.
Think about whose name to put on the check
Distributions from 529s can be made payable to the owner of the account (the parent or grandparent, for example), to the beneficiary (the student) or even to the school, Weltman says.
“The best way to do it is to make it payable to the beneficiary,” she notes. If you make it out to yourself, she says, the Form 1099-Q that the 529 administrator sends to report the withdrawal will indicate that the distribution didn’t go to the designated beneficiary.
“That’s going to perhaps — and I can’t say definitely — raise eyebrows with the IRS,” she says. “Then it’s up to the owner to justify that, indeed, the funds were used for education — which can be done, but obviously that’s burdensome.”
Don’t blow it on a flight home
Not every purchase during those college years is a qualified education expense in the eyes of the IRS, so be sure you’re thinking about the right costs when spending your 529.
For example, transportation typically isn’t a qualified educational expense, which means spending 529 money on plane tickets, bus passes or a new Mustang is a big no-no. Insurance and medical expenses also don’t count. Software required by the school counts; “Minecraft” doesn’t.
“I don’t think beer is covered,” Weltman adds.
Reduce, reuse, recycle
If Junior got a full ride or decides to take a “gap year” that ends up lasting a few decades, the money in that 529 account isn’t lost forever. You can transfer it to another of your kids or to another family member. You could even send yourself back to school. If that’s not an option, Weltman says emptying the account isn’t the worst thing in the world — you may have to pay the 10% penalty and taxes on the earnings, but the rest returns to you. Paying the account out to Junior could take some of the tax sting away if he’s in a lower tax bracket than you are, she adds.
Either way, just get it over with, Dillon adds. The longer the money sits in the account, the more it could grow there and the bigger that tax bite will be.
Tina Orem is a staff writer at NerdWallet, a personal finance website. Email: [email protected].