The tricky timing of 529 savings account withdrawals
College savings plans known as 529 accounts have earned widespread appeal among parents and families saving for a child's future education costs because they come with powerful tax advantages. Investment growth on money saved in these accounts is tax-free when withdrawn for specific expenses relating to a child's education.
Simply put, withdrawals from 529 Plan accounts can be tax-free when the money is used to pay for Qualified Education Expenses, or QEEs, as specified in IRS Publication 970. QEEs include tuition, fees, books, supplies and equipment. For students pursuing a degree on at least a half-time basis, QEEs also include a specified amount of room and board.
Because the current rules don't specify a deadline or age as to when money in a 529 plan must be distributed, people who've stashed a considerable amount of money in these accounts are well advised to keep it there and growing tax-deferred as long as possible.
However, many individuals have asked if the timing of withdrawals from a 529 plan account has to coincide with the timing of paying the QEE. The reason for the question is that same powerful advantage of tax deferral: The longer money stays in a 529 plan and compounds tax free, the bigger the financial benefit.
Thinking about how to make the most of this advantage leads many to ask a question along these lines: "If I use money from other sources to pay for my student's college costs incurred this year, but save the receipts and reimburse myself many years later by taking a 529 withdrawal, would that withdrawal still be tax-free?"
The answer is, it's not entirely clear. Surprisingly, the actual tax rules contained in section 529 and IRS Publication 970 don't spell out that the timing of expenses and distributions must match up in the same tax year. The IRS hasn't specifically said yes or no to that issue. But it approached the topic when it published Announcement 2008-17 in January 2008, which stated in part:
"Section 529 is silent regarding whether distributions must be made from a section 529 account in the same tax year as QHEEs (qualified higher education expenses) were paid or incurred. Concerns have been raised that individuals could allow the account to grow indefinitely on a tax-deferred basis before requesting reimbursement or use distributions in earlier years to pay QHEEs in later years."
The IRS and Treasury Department are now proposing to develop a new rule permitting recipients of 529 plan distributions to count only those qualifying expenses paid during the same calendar year as the distribution, plus expenses paid within the first three months of the following year. But that rule has yet to be implemented.
So although you won't find a rule on this explicitly stated anywhere in IRS publications or tax forms, the prevailing view by tax professionals is that 529 withdrawals must match up with the payment of the qualifying expenses in the same tax year. If you withdraw the money in December for a tuition bill that isn't paid until January, you risk taking a taxable withdrawal because you didn't have sufficient qualified education expenses during the year of withdrawal.
This position is based on longstanding tax-accounting principles known as cash basis, which nearly all taxpayers use.
But you do have some flexibility. When the 529 plan withdrawal is within any particular calendar year, the proceeds don't have to be traceable to a particular expenditure. So you can pay college bills today with whatever non-529 resources you have and wait until December before withdrawing from the 529 account.
Assuming your 529 funds are growing in value, this strategy at least maximizes your tax-free growth for the year.
