Tips for Tapping 529s

Given the tax benefits of 529 accounts, we generally recommend them to clients as the preferred vehicle through which to save for their children’s college tuition.  However, when withdrawing funds from a 529 account, there are a few guidelines that clients should keep in mind in order to maximize tax savings and avoid penalties.  With the distribution of 2nd semester tuition bills rapidly approaching, we wanted to offer these tips on the best way to make use of 529 savings.

Nonqualified Expenses. Ensure that you don’t use 529 funds for nonqualified expenses, such as student health insurance, yearbooks, or optional activity fees, even if they appear on the “tuition” bill from your child’s college.  You can use distributions from 529 accounts for tuition, fees, books, supplies, and equipment (including computers) that are required for enrollment, as well as room and board, if the student is enrolled at least half-time.  You will have to pay income tax and an additional 10% penalty on the investment earnings for any distributions beyond the total amount of qualified expenses.

Education Tax Credits. If you qualify for an education tax credit, make sure that you pay a portion of qualified tuition expenses out of pocket (e.g. from your checking account, savings account, or taxable investment account), not from 529 funds.  For those with adjusted gross income (AGI) under the relevant limits (see chart to the right), the American Opportunity Credit offers a 100% tax credit on the first $2,000 of qualified education expenses and 25% on the next $2,000.  Thus, to maximize this credit, $4,000 should be spent out of pocket on college expenses for each eligible student in your household.  The Lifetime Learning Credit offers a 20% credit on the first $10,000 of qualified education expenses.  To maximize this credit, $10,000 should be spent out of pocket per household (only one Lifetime Learning Credit is granted per taxpayer, regardless of the number of college students in the household that year).

529 Distributions. To do yourself and your tax preparer a favor, have your 529 distributions sent directly to your child’s college. This helps you (and the IRS, in the case of an audit) in verifying that the funds were used for qualified higher education expenses. Additionally, ensure that you request distributions from 529 accounts well in advance of the deadline for paying tuition. Virginia529, for example, indicates that account owners should allow seven to ten business days for their distribution request to be processed and the funds to be delivered.

Grandparent 529s. If your child’s grandparent or other relative has opened a 529 account or saved other funds to assist with college funding, and you have qualified for financial aid, you may benefit from waiting to tap those grandparent funds until the child’s senior year (or spring of junior year, if tuition can be paid in January). Payouts from grandparents will be considered income for your child in the year received and could significantly raise the “expected family contribution” for financial aid purposes.

If you have questions about these or any other issues related to college savings plans, please let us know.  We’re here to help!