Is your child heading off to college? Here's what you need to know about withdrawing dollars to pay the tuition bills.
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Withdrawing funds from a 529 plan may seem simple, but timing and tax-planning issues can complicate the equation.
Named for the segment of the tax code that authorizes them, 529 plans are a popular choice for college savings: Financial Research Corp. a Boston-based research firm, estimates that 25% of college-savings money is held in 529s. Earnings in the accounts grow tax-deferred, and no income tax is taken when the funds are withdrawn for qualifying expenses such as tuition, fees, supplies and equipment. A portion of room and board also can be funded via a 529, as long as the student is going to school more than half of the time.
It sounds like a straightforward calculation: Take out enough to cover as much of the student's qualifying expenses as possible. But before withdrawing the total cost of tuition from a 529 plan, families should understand the full tax picture.
Claiming a federal American Opportunity or Lifetime Learning tax credit, for example, can affect how much of a student's college expenses qualify, says Joseph Hurley, founder of savingforcollege.com .
Say a student's qualifying expenses for the first semester of freshman year total $20,000, including tuition. Parents may be eligible for a $2,500 American Opportunity credit, based on the first $4,000 in tuition they pay. If the parents claim that credit, only $16,000 in expenses could be withdrawn from the 529 plan tax-free; the earnings portion of any withdrawal above that amount would be subject to taxes.
High earners may not be able to claim these credits, so first determine whether you are eligible based on your income (see www.irs.gov/pub/irs-pdf/p970.pdf for more information). If you are eligible, decide in advance how much you are going to claim, and pay that portion of the tuition ($4,000 in the above example) out of pocket, rather than with 529 funds, Mr. Hurley says.
Similarly, scholarship money eats into the amount that can be withdrawn from 529s tax-free. Make sure you subtract any scholarship money from the amount you're planning to withdraw from a 529 to avoid taking out too much.
Who Gets the Check?
Checks from a 529 account can go to the account owner, the student or the school. Each option carries potential consequences, college-savings experts say.
There's no penalty for having the check made out directly to the account owner—typically a parent or grandparent—assuming the money is used for proper higher-education expenses. Still, the Internal Revenue Service may ask for substantiation and "no one likes getting the notice from the IRS in the mail," Mr. Hurley says.
Another option is to have the plan administrator write the check directly to the student. That way, if any portion of the distribution does end up subject to taxes, it will be on the student's tax return, and the student is likely to be in a lower tax bracket than the parents or grandparents, Mr. Hurley says.
A check written directly to a school also makes for easy tax accounting: The IRS can see clearly that the money went to education-related expenses. But there is a risk involved, Mr. Hurley says.
"Some schools may adjust the financial-aid amount if they see [money] coming from a 529 plan," says Mr. Hurley. While 529 accounts owned by parents are treated as parental assets and
don't count as income under federal financial-aid guidelines, schools can set their own rules regarding their own need-based awards. "They might see money from a 529 the same way as a scholarship and reduce financial aid the same way," says Mr. Hurley.
When a grandparent is the account owner, things get a little trickier: Financial assistance from a third party, including a grandparent, is counted as student income on financial-aid applications, and may be treated like a scholarship that reduces financial aid dollar for dollar, Mr. Hurley warns. If the family expects to qualify for need-based aid and there's a grandparent-owned 529, it may make sense to transfer the ownership of the account to the parent. There are no tax implications in such a transfer, Mr. Hurley says.
When Should I Withdraw?
To avoid tax penalties, be sure to pay college expenses in the same calendar year that you take money out of the 529 plan.
"It doesn't present a tricky issue when Junior gets in and Mom and Dad make the first payment in July and August," says John Heywood, a principal in the retail investor group at Vanguard Group. But when the second-semester bills are due in December or January, some account owners get tripped up by withdrawing from the plan at the end of one year and paying the expenses early the next year.
Although the funds don't have to be distributed and paid on the same day—in theory an account owner can take money out in April and pay the bills in August—it may make sense to take money out close to the time of the payment to avoid problems.
Also, if the plan administrator is writing a check directly to the school, allow several weeks of wiggle room to ensure the check clears, advises Mr. Heywood. Schools tend to process checks from parents and students immediately, but it may take longer for a check that comes directly from a 529 account, he says.
How Can I Maximize Savings?
Depending on who owns the account, it may make sense to reserve 529 funds for the later years of college. That's because of the possible impact on financial aid of distributions from 529 accounts held by third parties.
Say a grandparent has one year's worth of tuition in a 529 plan. If the funds are used to pay freshman-year expenses over two semesters, the student will have to report the money as income when filling out financial-aid forms for both sophomore and junior years, Mr. Hurley says.
If the 529 money is reserved for senior year, however, it will play no role in financial-aid calculations for the student's first four years of college, he says. (Any leftover 529 funds can be transferred to another child, niece, nephew or grandchild, or can be used for graduate school or other higher education.)
When it comes to investing 529 funds for a student nearing college age, be conservative. Many 529 plans already account for this, offering age-based options that will automatically shift savings into the least risky securities as the beneficiaries approach college age.
Some states have started offering FDIC-insured options within their 529 plans for people getting ready to pay tuition bills—an appealing choice in light of the 2008-09 financial crisis, when markets plummeted.
"It was catastrophic for many parents," says Deborah Fox, founder of the San Diego-based financial planning firm Fox College Funding.
Ms. Pessin is a writer in New York. She can be reached at email@example.com .