529 plans are one of the best options available to save for your child's college education. Named after a section of the tax code, 529 plans are state-operated savings plans that provide tax benefits as long as the money is used for qualified educational purposes.
State 529 plans operate in a similar fashion to 401(k) plans or IRAs in that your money is invested in the market through options you choose within the plan. Earnings grow free of taxes, and as long as the money is used to pay for educational expenses, the earnings are not taxed upon withdrawal. Because of this benefit, you have to be careful with the mechanics of withdrawal towards the end of the calendar year.
The mismatch of calendar years for tax purposes is a common mistake made by first-time users of the 529 plans. People are increasingly accustomed to automated financial systems, and 529 plans take some time and thought to execute properly. Colleges do not have access to the account; you have to initiate the withdrawal request yourself and specify the amount that is being withdrawn to pay costs.
Since semesters or quarters generally end in December and begin in January, the timing of the bill payment is important. Be sure to withdraw the 529 funds in the year in which you will pay the bill. If you intend to pay the bill in December, withdraw your funds in December. If you are targeting a January payment, withdraw the funds in January.
Bad timing can throw off your 529 payments in one other respect — 529 withdrawals are not instantaneously available for payment. It could take up to two weeks for the funds to be processed, so if you have waited until the last few days to make a payment, the funds may not be available. Not only could this cause you to incur late fees and other problems on the college's end, it may also cause the year-end mismatch problem if this scenario occurs in December.
If the tuition bill is due early in January and the 529 payments may take too long, how do you avoid falling into the mismatch trap? If you have the available funds, the simplest way is to pay the college tuition yourself out-of-pocket in early January and then immediately request reimbursement from the 529 plan. You will be short on cash for a week or two until the withdrawal is processed, but you will avoid potential IRS hassles. Have documentation in hand to prove that the expenses are at least as much as your withdrawal.
Another option that may be available is to coordinate with your 529 plan to have the withdrawal paid directly to the school instead of routing it through your account. In that case, the college will make the withdrawal in the correct calendar year — but this is something you will have to set up with your 529 plan and the college. It does not happen automatically.
Not sure about your options? Check with your 529 plan administrator and the college. It is in both of their best interests to have the transaction go as smoothly as possible, just the same as it is for you. A few minutes of clarification beforehand can save potential confusion and hours on the phone straightening out a disjointed payment situation — not to mention the agony of incorrectly filed taxes and a subsequent battle with the IRS. You know who is going to lose that battle.