4 mistakes to avoid with 529 education accounts
If you have a child heading off to college this fall and you've saved money in a 529 education savings plan, congratulations.
But as you get ready use this stash to pay college bills, be forewarned: You need to know the rules for taking withdrawals. You'll want to do them correctly to avoid delays and taxes.
Don't wait until last day to pay
The process of requesting a withdrawal is easy with most 529 plans. You can make distributions that are paid to yourself, your student or directly to the school. Electronic distributions generally take three to five business days. When made via check, they can take up to 10 business days.
So to ensure you have enough time for payments to be received, it's best not to wait until the last day to request a withdrawal. When sending checks to the school, in addition to its name and address, you should include your student's school ID number. It's also best to keep receipts of all school costs and withdrawals from the 529 plan account.
Only use for qualified expenses
Because the popular 529 college savings plans come with powerful tax advantages, a few rules must be followed to make sure withdrawals are tax-free. The investment growth on money saved in these accounts isn't taxable when withdrawn for what's known as qualified education expenses, or QEE, incurred in connection with a child's education.
These expenses include tuition, fees, books and supplies. QEE also includes equipment, such as computers, internet access and computer software. Room and board is also a QEE for students who are pursuing a degree on at least a half-time basis (limited to the allowance for on-campus accommodations). Additional expenses of a special needs student are also allowed. See IRS Publication 970 for some specific examples.
Avoid taking 529 withdrawals for these common expenses that don't qualify:
- Insurance, sports or club activity fees, and many other types of fees that may be charged to your students but aren't required as a condition of enrollment
- A computer, unless the institution requires that students have their own
- Travel costs to and from the school
- Sorority and fraternity fees
- Repayment of student loans
- Room and board in excess of the amount the school includes in its "cost of attendance" figures for federal financial aid purposes
Tip: If your student is living off campus, ask the financial aid department for the room and board allowance for students living at home with parents or living elsewhere off campus. If the student is living in school-owned dormitories, you can include the amount the school charges.
Use education tax credits first
Another mistake to avoid is taking 529 withdrawals for college costs that you also use to claim education tax credits. The rule is that the education costs you've declared for claiming either the American Opportunity tax credit (up to $2,500) or the Lifetime Learning credit (up to $2,000) cannot also be used to take tax-free withdrawals from a 529 account.
Since the tax credits are more valuable, you'll want to first use the QEE for claiming the applicable education tax credit. Then you can take withdrawals from the 529 to pay for the remaining QEE.
Don't make excess withdrawals
What happens if you do withdraw more than the amount that covers qualifying education costs? The excess withdrawal is called a nonqualified distribution, and you or your beneficiary (you get to choose who receives the money) will have to report it as taxable income and pay a 10 percent penalty on the investment earnings portion. The principal portion isn't subject to tax or penalty.
But here's how to avoid that hit: If it has been less than 60 days since the withdrawal, you can deposit the excess amount into another 529, and it will no longer be treated as a taxable distribution.