Because the IRS is involved, a spending strategy should be a necessity. 529 Plan distributions are free from federal income taxes if used to pay for qualified higher education expenses, which include tuition, room and board, computers and books and software that are related to course work.
Most 529 Plans have withdrawal forms available on their websites. Generally, you need to indicate the type of withdrawal, which investment option you want to take the funds from, and who should receive the funds. Each year that withdrawals are made, you or the plan’s beneficiary will receive a Form 1099-Q that shows the total distributions for the year.
Plan funds can be made payable to the school, to the account owner, or to the beneficiary. If you have funds distributed directly to the school, it alleviates any questions on whether the funds were used for qualified higher education expenses. However, such payments can trigger a financial aid adjustment that may not happen otherwise. Consider having 529 Plan withdrawals paid to the beneficiary. If you unintentionally withdraw more than you need, you should be better off having your child report the income, since the student is likely in a lower tax bracket.
If your total adjusted qualified higher education costs are more than or equal to your withdrawal, nothing needs to be reported on your taxes. However, if you withdraw more than your qualified expenses, some or all of the earnings reported on Form 1099-Q must be included as income on someone’s Form 1040. You may be required to pay a 10 percent penalty for withdrawing funds for non-education expenses.
It is highly recommended that you keep your receipts, invoices and other documents and information to substantiate your transactions as qualified higher educational expenses. This is an area the IRS watches, so if you are audited, you will want to have complete records. It is also important to withdraw the funds in the year that you pay the expenses. If you do not pay expenses until January 2014, do not withdraw the funds in December 2013; otherwise, you will have a mismatch between withdrawals and total expenses when filing your taxes.
When you are planning your withdrawals, you may also want to work with a CPA, or tax adviser, to coordinate your 529 Plan withdrawal with the American Opportunity Tax Credit, which is up to a $2,500 tax credit on the first $4,000 in qualified higher education expenses. If you are eligible for this credit, you must reduce the amount you withdraw from your 529 Plan to avoid paying taxes on the earnings portion of the non-qualified distribution. Basically, you cannot apply a tax credit to expenses that were paid with 529 Plan funds. Likewise, if your student is fortunate enough to have received scholarship money, a tax adviser should be able to determine what costs you should apply to the scholarship, the tax credits, and your 529 Plan withdrawals for you to receive the most tax benefit.
William G. Lako, Jr., CFP®, is an Executive in Residence at Kennesaw State University’s Coles College of Business and a principal at Henssler Financial. Mr. Lako is a CERTIFIED FINANCIAL PLANNER™ professional.