529s Putting money in is easy – getting it out, not so much!

Since the day they were born, I have had 529 accounts set up for each of my sons. My oldest son is starting college this week and I have suddenly realized that while putting money into a 529 account is quick, easy and stress free, taking money out is none of those things. For one thing you will automatically be receiving a new tax form: the 1099-Q. You’ll need this come tax time. Much more problematic than the new tax form are issues such as: Who should receive the monies from the 529?; What does the IRS recognized as “qualified education expenses”?, What is the effect of the 529 on certain tax credits?; And the importance of keeping tax years straight. 

Who should get the funds?

The first, and perhaps the easiest decision to make is who should receive the 529 withdrawal. While only the owner of the account (you) can authorize the taking of funds, you have three options on who should receive it: The owner of the account can receive the distribution; The student can receive the distribution; You can have the money sent directly to the school. In some ways having the money sent directly to you, is the easiest solution. You get the funds, you control the payments, and if a mistake is made you have the opportunity to correct it before the time limit runs out (more later).  Some advocate having the money sent directly to the student. Arguments include that it encourages responsibility and that if mistakes are made the tax penalty will be at the students lower rate. As the parent of a teenage boy, I’ll pass on this option without further comment. Lastly, you can send the money directly to the school. This sounds like a great idea except it can adversely affect financial aid so you should speak to the school first. In addition, you cannot send money to the school for items like supplies, computers, books and off-campus rent. So its never really a complete solution. 

What exactly is a “qualified education expenses”

According to IRS regulations, money taken out of a 529 plan is tax free as long as the money is used to pay for “qualified education expenses (QEE),” and thats where things a murky. If you take out too much money or payed for something that is not a QEE then you could be forced to pay tax AND a 10% penalty on the earnings portion of the withdrawal. So what exactly is a  QEE? well some stuff is obvious such as tuition, as well as required: fees, books, supplies, and related equipment. Note the qualifier : required. Anything not specifically required by the school will not qualify. The purchase of computers and internet access are also a QEE. Room and board costs are entirely covered if your student lives on campus; however, if your student lives off campus then only the amount that the school includes in its “cost of attendance” figures for federal financial aid purposes are considered a QEE. If you have a special needs student, necessary expenses may also be covered. 

…. whats not a “qualified education expenses”

Whats not covered? Transportation, student loans, insurance, sports / club activity fees, and many other types of fees that may be charged to your student but are not required as a condition of enrollment. Seems straight forward enough but what if a school requires and charges a “health fee” that funds a student health center or a mandatory transportation fee that funds a campus bus? The IRS has ruled that these are ineligible. Well then, what about required  student activity fees, aren’t they ineligible? Actually, these may be qualified education expenses! Can you see the confusion? Recently, on a chat board frequented by savvy financial types, the question of whether you can deduct a required “orientation fee” inspired a lively debate and no clear answer. So as not to end up with a nasty tax surprise its best to pay for things that are clearly QEEs and pay for the rest with other monies. 

What about the American opportunity tax credit?

The American opportunity tax credit (AOTC) and the lifetime learning credit (LLC). provide  higher education tax credits for individuals who pay higher education tuitions and have a modified adjusted gross income of less than  $66,000 ($132,000 for joint filers) for the LLC or $90,000 ($180,000 for joint filers) for the AOTC. These are valuable tax credits; however, education expenses paid with money from a  529 do not qualify toward the credit! Be sure to consider this when calculating taxes or you could be in for an unpleasant surprise.

Its tax years not academic years that matter!

I cannot overemphasize the importance and difficulty of keeping years straight. Tax years and academic years are not the same. Withdrawals taken from a 529 account must match up with the payment of expenses occurring in the same tax year. Recently I signed my son up for a campus meal plan – totally a qualified education expense. The cost was quite clearly stated on the university webpage – It was ~$4,000. Ouch. When I made my withdrawal from the 529 plan I expected a charge for the the 4K to appear on his bursar bill. Actually only about two-thirds of it appeared. When I enquired further, I discovered that the rest will be billed after Jan 1. As a result, I can either take the tax penalty on the extra I withdrew or roll the money into another 529 plan. I have up to  60 days from the date of the distribution to open and fund a new 529 or pay the penalty. (BTW this only works if you have not rolled over the students 529 account in the previous 12 months).

Lastly, plan ahead. I while I  knew exactly how to put money into a 529, I had no clue how to get it back out! It took me a little while to figure out the process and then another week for a check to arrive from the plan – all the while the bursar was sending me concerning notices about being “overdue.”

The 529 is a phenomenal saving instrument that you will want to make use of; however taking money out of the plan and not tripping up and triggering a tax penalty requires some planning. Take some time before you actually need the money to familiarize yourself with the process.