Taking money out of a 529 plan is more complicated than putting money into a 529 plan. And when the time comes to pay for college, you need to make sure you take your money out correctly.
If you do it incorrectly, you may owe taxes and a 10% tax penalty, plus recapture of state income tax breaks attributable to the distribution.
If you’re getting reading to take 529 plan distributions to pay for college (or K-12 tuition, student loans, or even a Roth IRA rollover), here’s what you need to know so you don’t end up receiving a tax penalty.
How To Ensure A Tax-Free Distribution
A distribution from a 529 plan is tax-free if it is limited to qualified education expenses.
The IRS does not allow double-dipping, so each qualified expense can justify just one tax break. For example, you can’t use the same tuition dollars to justify both a tax-free distribution from a 529 plan and the American Opportunity Tax Credit (AOTC).
Accordingly, after you identify the qualified education expenses, you must subtract those expenses that have been used with another tax break from the total. The qualified distribution from the 529 plan must be limited to what’s left, or part of it will not be tax-free.
Qualified Education Expenses
Qualified education expenses include tuition, fees, books, supplies, equipment, computers, Internet access, software, peripherals and special needs expenses. Also, if the student is enrolled on at least a half-time basis, qualified expenses include room and board.
Room and board may include rent for an off-campus apartment, but only up to the allowance for room and board in the college’s official cost of attendance figure. This is sometimes called a student budget, for the student’s specific living arrangement.
Most colleges have three or four student budgets, depending on whether the student is living on campus, in an apartment, with family, or on a military base. If the student is living on campus in housing that is owned or operated by the college, room and board may be based on the actual invoice amount, if it is higher than the allowance in the student budget.
Eligible educational institutions include all colleges and universities that are eligible for Title IV federal student aid. This includes undergraduate and graduate institutions, as well as institutions that offer Associate’s degrees and certificates.
Qualified expenses do not include other expenses, such as transportation and health insurance.
Qualified expenses may include up to $10,000 per borrower (lifetime limit) in student loan repayment for qualified education loans borrowed by the beneficiary or the beneficiary’s siblings. Qualified education loans include all federal and most private student loans.
Some families may borrow student loans instead of taking a distribution during a down stock market. Later, after the stock market has recovered, they can take a qualified distribution to repay the student loans.
Make sure you find your state in our guide to 529 plans to ensure that your state allows student loan payments as qualified expenses.
Adjustments To Qualified Expenses
The qualified education expenses must be reduced by the amount of tax-free educational assistance.
Tax-free educational assistance includes:
- Tax-free scholarships and grants
- Employer-provided educational assistance
- Veterans’ educational assistance
- Qualified expenses used to justify the American Opportunity Tax Credit (AOTC) and Lifetime Learning Tax Credit (LLTC)
The remaining qualified education expenses can be used to justify a qualified distribution from a 529 plan, up to the amount of the qualified expenses.
Make sure you don’t request a distribution that exceeds this figure.
Timing Of The Distribution
The timing of the distribution matters in several ways.
For a distribution to be qualified, the qualified expenses must be paid in the same tax year as the distribution.
If you take a distribution in December to pay next year’s tuition, it will be non-qualified unless you actually pay next year’s tuition in December. The distribution and expense must be paid in the same tax year.
The IRS also does not allow you to pay for qualified expenses one year, then take a qualified distribution several years later. Otherwise, you’d be able to let the 529 plan to grow in value for several decades and then take a tax-free distribution that is almost entirely earnings (like they currently allow with HSAs).
Don’t wait until the last minute to request a distribution, as it can take weeks or even months for a 529 plan to issue and send the payment. If you request a distribution in December, you might not receive it until the next year. You should request the distribution early enough so that it will be received in the same tax year as the qualified expenses are paid.
For this reason, it is best to request a distribution by electronic funds transfer (EFT) instead of check, since it can take longer for a check to be delivered by the U.S. Postal Service. However, some 529 plans limit transfers to only the account owner’s bank account.
Paying for school with a 529 is a great way to get expenses paid. But what about budgeting while you’re in school? Check out The College Investor’s College Budgeting Guide.
Using Distributions Strategically
There are several factors that may affect how much of a distribution you take from your 529 plans each year. Consider the following questions.
- Do you spread it out evenly over all four years? This approach is focused more on cash flow than on maximizing financial aid or tax breaks.
- Do you front-load the distributions to reduce the need to borrow during the early years? When you do it this way there’s less time for interest to accumulate on the student loans during the in-school years.
- Do you back-end the distributions? This helps maximize the return on investment during the in-school years.
- Do you try to optimize your use of tax credits, like the American Opportunity Tax Credit (AOTC)? The AOTC is worth more per dollar of qualified expenses than a tax-free distribution from a 529 plan.
For strategic optimization of the tax credits, you’d carve out $4,000 a year in tuition and textbook costs to qualify for the maximum AOTC, assuming you’re below the income phaseouts. The income phaseouts are $80,000 to $90,000 for single filers and twice that for married filing jointly. You can pay for the $4,000 using cash or student loans.
If you need to borrow, you will start with the senior year student loan limits back to the freshman year, figuring out how much you’ll need to borrow each year.
Dependent students can borrow up to:
- $5,500 in federal student loans as a freshman
- $6,500 as a sophomore
- $7,500 as a junior
- $7,500 as a senior
So, if you will need to borrow $20,000, you’ll borrow $7,500 as a senior, $7,500 as a junior and $4,000 as a sophomore.
After addressing the AOTC and student loan limits, you’ll pay for the remaining expenses using qualified distributions from your 529 plans.
In the end, it can make sense to simply spend the 529 plan first in lieu of student loans.
What If You Take Too Much of a Distribution?
If you happen to take too much of a distribution, the excess will be non-qualified. The earnings portion of a non-qualified distribution is subject to income tax at the recipient’s rate, plus a 10% tax penalty, and possible recapture of state income tax breaks attributable to the distribution.
The 10% tax penalty is waived when the non-qualified distribution is caused by the receipt of tax-free educational assistance. The waiver is limited to the amount of the qualified expenses associated with the tax-free educational assistance. You will still have to pay income tax on the earnings even when the tax penalty is waived.
Examples of tax-free educational assistance include tax-free scholarships or grants, veterans’ educational assistance, employer-provided educational assistance, and attendance at a U.S. military academy, as well as the qualified expenses that justify the receipt of the American Opportunity Tax Credit (AOTC) and Lifetime Learning Tax Credit (LLTC). The tax penalty is also waived when the student dies or becomes disabled.
You can correct 529 plan over-withdrawals within certain time frames.
Re-contributing Refund Back Into A 529 Plan
If you get a refund from your college or university, you have a few options for avoiding the income tax and tax penalty on a non-qualified distribution.
One option is to use the refund to pay for other qualified expenses in the same tax year.
Another option is to recontribute all or part of the refund to a 529 plan. The ability to put a college refund back in a 529 plan was enacted by the Protecting Americans from Tax Hikes Act of 2015 (PATH Act). The IRS published guidance concerning re-contributions, rollovers and qualified higher education expenses in Notice 2018-58 (PDF File).
The re-contribution can be to the same or a different 529 plan, but it must be for the same beneficiary as the original 529 plan. The re-contribution is capped at the amount of the refund. Only refunds of qualified higher education expenses are eligible. The refund must be re-contributed within 60 days of receipt. Re-contributions do not count against the 529 plan’s contribution limits.
Picking A Plan Or Portfolio For The Distribution
If there are several portfolios within the 529 plan. If you are not fully distributing the entire 529 plan, you may be able to choose the portfolio from which the distribution is taken.
Some 529 plans let you specify the portfolios and some do not. If the 529 plan does not allow you to specify the portfolios, the distribution will be taken proportionally from all of the portfolios.
Likewise, if you have several 529 plans for the same beneficiary, you can choose the 529 plan from which the distribution is taken.
If the distribution is a qualified distribution, choose the 529 plan with the highest percentage earnings, since the earnings portion of the distribution will be tax-free.
If the distribution is a non-qualified distribution, choose the 529 plan with the lowest percentage earnings. This will minimize the taxes and tax penalty on the non-qualified distribution by reducing the percentage of the distribution that is earnings.
Recipient of Distribution
The 529 plan distribution can be made payable to the account owner, the beneficiary or paid directly to the educational institution. If the distribution is paid directly to the educational institution, it is treated as though it is paid to the beneficiary.
Families are pretty split 50/50 one whether they pay the school directly, or reimburse themselves. There’s no right or wrong answer.
It is important to keep receipts, canceled checks, bills, statements and other documentation of purchases of qualified expenses.
Due to federal privacy rules, a student’s parents will not necessarily get to see the student’s bills and other college expenses, even though they may be paying for it.
There are a few options. One is for the student to sign a FERPA waiver, to allow the parents to get copies of the bills. Otherwise, the parents will have to ask the student to provide them with copies of the receipts and bills.
If the distribution is a non-qualified distribution, it may be better to have it paid to the beneficiary instead of the account owner, since the beneficiary will usually be in a lower tax bracket. The earnings portion of a non-qualified distribution is considered taxable income to the recipient. However, some 529 plans limit non-qualified distributions to the account owner.
Impact on Financial Aid
Sending the payment directly to the college or university can make it easier to demonstrate that the distribution was used to pay for qualified higher education expenses. However, some colleges may treat the payment as a resource (reducing financial aid eligibility on a dollar-for-dollar basis) instead of as a payment on the account.
Qualified distributions from a 529 plan should not otherwise affect eligibility for need-based financial aid.
- A 529 plan owned by the student or parent is reported as an asset on the FAFSA, but qualified distributions are ignored.
- A 529 plan owned by anybody else, such as a grandparent, is not reported as an asset on the FAFSA.
Previously, qualified distributions from such a 529 plan would be reported as untaxed income to the student, reducing aid eligibility by as much as half of the distribution amount. But, FAFSA simplification has eliminated the question where this was reported on the FAFSA. Distributions from a grandparent-owned 529 plan will no longer affect aid eligibility, assuming no future changes.
Non-qualified distributions, however, will be reported in income on the recipient’s federal income tax return and thus affect aid eligibility. Part of this may be sheltered by the student or parent income protection allowance.
Need to open another 529 in a different state? Here’s our resource for where to open a 529 in your state.
How To Request A Distribution
Distributions may be requested by the 529 plan’s account owner, not the beneficiary. If the 529 plan is a custodial 529 plan, distributions may be requested by the custodian.
You can request a distribution online, using the 529 plan’s website.
You can also download a withdrawal request form from the 529 plan’s website and mail it to the plan. A Medallion Signature Guarantee may be required if the withdrawal is for a large amount or there have been recent changes in the account. (A notarized signature is not sufficient.) There may also be an extra waiting period for recent changes, typically at least 15 days.
Some 529 plans allow a distribution to be requested by telephone and some do not.
When requesting a distribution, you will need to provide the 529 plan account number, the account owner’s name and Social Security Number (SSN) or Taxpayer Identification Number (TIN), the beneficiary’s name and SSN or TIN. You will also have to specify the recipient of the distribution and whether the distribution is qualified or non-qualified.
Reporting Distributions To The IRS
The 529 plan will report the distribution to the IRS and the recipient on IRS Form 1099-Q.
Box 1 of the 1099-Q provides the total distribution amount. Box 2 provides the earnings portion of the distribution and Box 3 provides the contributions portion of the distribution. Box 2 and Box 3 should sum to be the same as the amount listed in Box 1.
Only the earnings portion of a non-qualified distribution is reported on the recipient’s income tax returns. The earnings are assumed to be proportional between the qualified and non-qualified portion of the distribution, based on the ratio of the adjusted qualified expenses (after subtracting qualified expenses that are attributable to other tax breaks) to the total distribution amount. This ratio is the percentage of the distribution that is qualified. Multiply this ratio by the earnings portion of the distribution and subtract the result from the earnings portion of the distribution to determine the non-qualified earnings.
The non-qualified earnings are reported on line 8z (Other Income) of Schedule 1 of IRS Form 1040.
If a non-qualified distribution is subject to the 10% tax penalty, use IRS Form 5329 (Additional Taxes on Qualified Plans) to calculate the amount of the penalty and report it on line 8 of Schedule 2 of IRS Form 1040.
1099-Q forms are usually provided by January 31.
The post How To Pay For College With A 529 Plan [529 Plan Distributions] appeared first on The College Investor.
