More than ever, 529 college savings plans are being tapped for higher education expenses. In 2013, distributions were taken from 1.6 million 529 accounts, according to the College Savings Plan Network, which compiles data about these tax-advantaged accounts designed to pay for college expenses.
529 plans, like other tax-savings vehicles, are excellent ways to grow savings unencumbered by taxes. But in order to stay tax-advantaged, account owners need to be certain to take withdrawal in a way that doesn’t result in taxable income. Distributions may require special handling to insure your withdrawals don’t upset other components of college financing, such as financial aid packages and student loans. Or even worse, run afoul of regulations that may result in a taxable event, possibly including penalties.
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Avoid the mistakes some 529 savers have made in the past:
Get the family on the same page. Communicate and avoid double trouble. If there are multiple 529 accounts intended for a particular student, make sure all account owners (for example, the parent and grandparent) don’t take multiple distribution for the same expense, or one may be stuck with a taxable event.
Make sure educational expenses are qualified. Tuition may be a cut-and-dry example of a qualified educational expense, just as room service in Miami during spring break is an example of an expense that doesn’t qualify. But in between, lines can sometimes blur. Computer equipment is a prominent example: Unless the college specifically requires the purchase of computer equipment, it isn't considered a qualified expense. Other expenses that don't qualify are travel expenses, room and board, and research.
Typically, the college will inform the student of the total amount of qualified expenses billed for a calendar year by furnishing a 1098-T form the following January. Many colleges fill in box 2, which is the total qualified expense billed the student that year. 529 withdrawals in excess of that amount may be taxable.
Know the advantage and disadvantages of the 529 recipient. When making a 529 withdrawal, the funds can be made to the order of one of three parties: the account owner, the student (who is the beneficiary), or the school. Each has advantages and disadvantages.
Having the funds made out to the account owner offers greater flexibility. For example, the owner can choose to pay the qualified expenses with other funds and then take a 529 distribution at a later date in the calendar year. Be prepared for a follow up from the IRS though: it may query you to make sure the funds were indeed used for qualified expenses.
By making the funds payable to the student, if there is a circumstance that results in a taxable event, the student will presumably owe less in tax on that income. But that student will now have income, which may affect financial aid packages in a future academic year.
And by making the school the distributee, you may side step potenital nonqualified expense issues, but it may affect needs-based financial aid packages offered by the college, according to Joseph Hurley of savingforcollege.com.
Don’t wait until the last minute. Especially in December. Often, it’s the spring semester payment that can cause tax problems, as it’s usually billed late in the calendar year. Avoid the headaches that may arise from taking a 529 distribution in a year different from the year the qualified expense was billed.
Be mindful of other education tax credits. If the taxpayer claims an American Opportunity tax credit or a Lifetime Learning credit, then that credit will lower the qualified expense amount one can claim.
For more information, consult IRS Publication 970, Tax Benefits for Education. —Chris Horymski
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