college

3 ways to make a 529 plan withdrawal

Joseph Hurleyq_v2.gifDear College Money Guru,
Does money from a 529 plan have to be paid directly to the school?
-- Melissa

a_v2.gifDear Melissa,
No. Most 529 plans will give you the option of making the withdrawal payable to the account owner (you), to the account beneficiary or to the school that the beneficiary is attending. The option you choose will not affect your right to exclude account earnings from income taxes.

The test for determining if 529 plan withdrawals are entirely tax-free is whether the account beneficiary has incurred qualified higher education expenses, or QHEE, during the tax year equal to, or greater than, all withdrawals from 529 plans for that beneficiary. For income tax purposes, it doesn't matter who receives the money or what the withdrawn funds are actually used for.

Qualified higher education expenses include tuition, mandatory fees, and required books, supplies and equipment for the beneficiary's enrollment and attendance at an eligible post-secondary institution. A limited amount of room and board is included for students attending at least half-time. And through the end of this year only, computer purchases and Internet access are included in QHEE even if not required by institution. Total QHEE must be reduced by the amount of tuition and fees used in claiming the American Opportunity Tax Credit, or the Hope credit, or the Lifetime Learning Credit.

I generally advise that you make the withdrawal from your 529 plan payable to the beneficiary, and that the beneficiary uses that money to pay college bills. The IRS will usually accept your tax returns without further question, and if you do undergo an audit, the earnings exclusion should be easy to substantiate. In contrast, withdrawals made payable to the account owner seem to be attracting extra scrutiny from the IRS, even when you have properly accounted for the beneficiary's college expenses.

The third option, making the withdrawal payable to the school, has a couple of advantages, but also one big disadvantage. It is often the easiest approach since it means you do not have to handle the funds yourself. And it assures proper timing because the withdrawals and expenses will always match up in the same tax year. The timing issue can be a problem if the withdrawal goes directly to you or to the beneficiary. That is, you could be facing extra taxes and penalties if expenses are not paid in the same calendar year as the withdrawals.

The disadvantage, and the reason I hesitate to recommend withdrawals be made payable to the school, is that some schools will seek to adjust the student's financial aid award when they receive a check directly from a 529 plan. You can alleviate this concern by first contacting your child's college and asking about their financial aid policies.

Be sure to read the disclosures from your own 529 plan to fully understand the procedures for requesting withdrawals. Most prepaid tuition plans and a few 529 savings plans do not provide all three of the options I described above.

Bankrate's content, including the guidance of its advice-and-expert columns and this Web site, is intended only to assist you with financial decisions. The content is broad in scope and does not consider your personal financial situation.  Bankrate recommends that you seek the advice of advisers who are fully aware of your individual circumstances before making any final decisions or implementing any financial strategy.  Please remember that your use of this Web site is governed by Bankrate's Terms of Use.

Read more College Money Guru columns and more stories about college financing. To ask a question of the College Money Guru, go to the "Ask the Experts" page, and select "College Financing" as the topic.

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