Tax-savvy ways to tap your 529 plan

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Hold on before tapping your savings to pay fall tuition bills. Families planning to use money in a 529 college savings plan have tax and financial aid issues to consider before taking a 529 withdrawal. Named for section 529 of the Internal Revenue Service code, 529 college savings plans are state-sponsored investment vehicles available in all 50 states and the District of Columbia that allow higher education funds to grow tax-free — at the federal level, at least. Many offer state tax incentives, too.

So, bone up on these rules. While you won’t be tested and graded on how much you know, your student stands to lose out on financial aid if you’re not careful. How much money you withdraw from your plan, how you use it and when you make the 529 withdrawal can greatly impact the tax breaks you might otherwise get. Here’s what you need to know.

529s won’t cover the total cost of attendance

According to the IRS, families may use 529 college savings plans to pay for “qualified education expenses” only. That includes such costs as tuition, mandatory fees, and any books, supplies and equipment the school requires you to buy. Students enrolled at least half-time may also use 529 funds to pay for room and board, but only the amount the school charges students who live on campus. Some expenses that may be incurred at school don’t count as qualified expenses, including transportation, entertainment costs and computer expenses if the computer isn’t required by the school.

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Greg Dosmann, principal partner of marketing and education savings for Edward Jones investment firm, says parents should be able to prove their funds really did go to qualified expenses.

“The owner of the 529 should keep bills, invoices from the school (and) receipts that cover all eligible (qualified education) expenses,” he says.

Families will have to pay a 10 percent penalty and income tax on plan earnings for any 529 money that’s used for a nonqualified education expense, according to the U.S. Securities and Exchange Commission.

Scholarships are the exception, says Andrea Feirstein, managing director of AKF Consulting Group, a strategic advisory group that works with state 529 plan administrators. “You can take a nonqualified withdrawal up to the amount of the scholarship, and while you will pay taxes on the earnings, you won’t pay the additional 10 percent penalty that’s imposed on a nonqualified withdrawal,” she says, adding that parents should ask for a scholarship receipt for their accounting records. Parents may also roll 529 funds over to another beneficiary if a student wins a scholarship.

529 funds conflict with tax incentives

The federal government offers sweet tax incentives to college-bound families, but you can’t use 529 funds to get them. That would be considered double-dipping. For example, the American opportunity tax credit allows families of first-time undergrads to deduct the first $2,000 spent on qualified education expenses and 25 percent of the next $2,000. To qualify for the full credit, single parents must have adjusted gross incomes of $90,000, or $180,000 if married filing jointly, reports the IRS.

“Basically every family in America is going to want that tax credit … In order to get that $2,500 tax credit, you have to use up basically $4,000 in tuition expenses,” but you can’t claim those expenses to get both the tax credit and a tax-free 529 withdrawal, says Rick Darvis, co-founder and director of the National Institute of Certified College Planners, a professional association for college planning specialists.

The less lucrative lifetime learning credit also provides a $2,000 credit for single-filer households with adjusted gross incomes of $61,000 or less ($122,000 if married filing jointly), but families will have to shell out $10,000 in qualified expenses from funds outside of a qualified plan to get it. Families should factor in whether they’ll be claiming a tax credit when deciding how much to pull from a 529 plan.

Timing counts

To ensure that a 529 withdrawal is penalty- and tax-free, Sid King, an education consultant with TIAA-CREF Tuition Financing, the organization that administers 10 state 529 plans, advises families to make their withdrawal in the same calendar year as their tuition payments.

“Can you withdraw it this year based upon next year’s expense? There’s no guidance from the IRS that we’ve seen,” he says. “If (the 529 withdrawal is) in the same year, you should be fine, but if it’s outside of that year, there’s no documentation that says yes, that’s acceptable, or no, that’s not.”

Timing also counts for relatives. When calculating your financial aid package, the federal methodology excludes assets held by grandparents and other relatives. Once Gram and Gramps start sending in checks, however, the rules could change, says AKF Consulting Group’s Feirstein.

“There’s the possibility that that (money) may be viewed as income for the child for the following year, when the financial aid gurus are making their decisions about how much financial aid you should be entitled to,” she says.

Whereas 529 accounts held in a parent’s or dependent student’s name are assessed at a rate of up to 5.6 percent — meaning that out of every $100 in a 529 plan, up to $5.60 can be subtracted from a student’s federal financial aid package — student income is assessed at a 50 percent rate. A check from the grandparents could cut a student’s financial aid package in half.

To avoid getting hit with a financial aid cut, relatives can hold off on making a 529 withdrawal until after students have applied for financial aid their senior year. Or they can transfer their 529 funds into an account held by the parent or student.