April 24, 2017

The big advantage of Section 529 college savings plans is that withdrawals used to cover qualified higher education expenses are free from federal income tax (and usually state income taxes too). That part is very easy to understand, but the full story on withdrawals is not so simple. What are qualified expenses? What happens if you take out money for expenses that aren’t qualified?

Here are five important facts that you should know about 529 plan withdrawals:

Fact #1: You Have Three Basic Payment Options

  • You can direct the plan to make a withdrawal check out in the name of the account beneficiary (meaning the student for whom the account was set up, usually your child or grandchild).
  • You can direct the plan to pay the educational institution directly.
  • You can direct the plan to make a check out in your name as the account owner or plan participant (meaning the person who established and funded the account).

Assuming the withdrawn funds will be used for the benefit of the account beneficiary (to pay for his or her college costs or for whatever other reason), having the check made out to him or her or to the educational institution is the recommended option. If the money will be spent on college costs, you can have the beneficiary endorse the check over to you so you can control the spending.

If the check is made out to the educational institution, that is not a concern. If you as the account owner will keep the withdrawn funds for your own benefit, having the check made out in your name is the recommended option. Handling withdrawals in this fashion makes it easier to “follow the money” for tax purposes.

Beware: As a matter of state law, you’re not permitted to keep a withdrawal from a 529 account that was funded with money from a custodial account established for the 529 plan beneficiary (your child or grandchild) under a state’s Uniform Gift to Minors Act (UGMA) or Uniform Transfer to Minors Act (UTMA). In this case, the money in the custodial account belongs to the kid, and the money in the 529 account does too because it came from the custodial account. In other words, a 529 account that was funded with custodial account money belongs to the child for whom the custodial account was set up. Therefore, withdrawals must be used for the benefit of the child, and not for your own purposes.

On the other hand, if you funded the 529 account with your own money, you can take withdrawals and do whatever you want with them because it’s your money. Just make sure you understand the tax implications.

Fact #2: The IRS Knows About Withdrawals

When a withdrawal is taken from a 529 account, the plan is supposed to issue a Form 1099-Q, Payments From Qualified Education Programs, by no later than February 1 of the following year.

If withdrawal checks were issued to the account beneficiary, the 1099-Q will come to the beneficiary with his or her Social Security number on it. If checks were issued to you as the account owner, you will receive the form with your Social Security number on it.

Line 1 of the 1099-Q shows the total withdrawn for the year. Assuming the account made money, withdrawals will include some earnings and some tax basis from contributions.

  • Withdrawn earnings are shown on line 2 of the 1099-Q. They may or may not be tax free.
  • Withdrawn basis amounts are shown on line 3. They are always free of any federal income taxes or penalties.

The IRS gets a copy of the Form 1099-Q, so the government knows withdrawals were taken and who received them.

Fact #3: Some Withdrawals May Not Be Tax-Free, Even in Years with Big College Expenses

When the 1099-Q shows withdrawn earnings, the IRS might become interested in looking at the recipient’s Form 1040, because some or all of the earnings might be taxable. Here’s how the tax rules work.

Withdrawn earnings used for the benefit of the account beneficiary are always federal-income-tax-free when total withdrawals for the year do not exceed what the IRS calls the adjusted qualified education expenses, or AQEE, for the year. These expenses equal:

  • The account beneficiary’s tuition and related fees for an undergraduate or graduate program;
  • Room and board (but only if he or she carries at least half of a full-time load); and
  • Books and supplies, computer and Internet access costs.

Once you add up the above costs, then subtract:

  • Costs covered by Pell grants, tax-free scholarships, fellowships, tuition discounts and veterans’ educational assistance;
  • Costs covered by employer-provided educational assistance or any other tax-free educational assistance (not including assistance received by a gift or inheritance);
  • Expenses used to claim the American Opportunity or Lifetime Learning tax credit; and
  • Expenses used to claim the tax deduction for college tuition and fees.

When withdrawals exceed adjusted qualified education expenses, all or part of the withdrawn earnings will be taxable. This little-known fact is an unpleasant surprise for some people.

Example: Ben has $36,000 in college expenses. He receives $24,000 in tax-free scholarships and tuition discounts, so his adjusted qualified education expenses are only $12,000. His parents arrange for a $36,000 withdrawal from Ben’s 529 account. Assume the withdrawal includes $6,000 in earnings. The parents use the money to cover the $12,000 of qualified education expenses, plus Ben’s clothing, pizza, and other incidentals, as well as a car for him to get back and forth to school. Since the $12,000 of adjusted qualified education expenses are only one-third of the 529 withdrawal, only one-third of the withdrawn earnings, or $2,000, is tax free. The remaining $4,000 is taxable and should be reported on the miscellaneous income line of Ben’s Form 1040. Depending on Ben’s overall tax situation and whether the Kiddie Tax applies to him, the tax hit on the $4,000 may or may not be a significant percentage. (The $4,000 of taxable earnings Ben receives counts as unearned income for purposes of the Kiddie Tax rules.)

Tax-wise steps: The parents should direct the plan to issue the withdrawal check in Ben’s name rather than their names. Then, the parents should have Ben endorse the check over to them so they can control the spending. That way, Ben will be issued the 1099-Q and will bear the tax consequences.

Example: This time, assume Ben has $36,000 in adjusted qualified education expenses because he doesn’t receive any scholarships or tuition discounts. Since his qualified expenses do not exceed the amount taken from his 529 account, the withdrawn earnings are federal-income-tax-free. Therefore, the $6,000 is not reported on Ben’s Form 1040.

Fact #4: You Can Usually Keep Withdrawals for Yourself — But there May Be Taxes

Assuming the 529 account was funded with your own money (as opposed to money from your child’s custodial account), you are free to change the account beneficiary to yourself and take federal-income-tax-free withdrawals to cover your own qualified education expenses if you decide to go back to school.

Earnings included in withdrawals that you choose to use for purposes other than education must be included in your gross income and will probably be hit with a 10% penalty (explained below).

However, if you liquidate a 529 account that is worth less than you contributed (because of the stock market), there won’t be any withdrawn earnings, so you won’t owe anything to the IRS. You might even be able to claim a tax-saving write-off for your loss.

Fact #5: Withdrawals Not Used for Education Can Be Hit with a Penalty

As explained earlier, the earnings included in 529 account withdrawals that are not used to cover the account beneficiary’s qualified education expenses must be included in gross income. In other words, the earnings are taxable. But there’s more.

According to the general rule, taxable earnings are also hit with a 10% penalty tax. However, the penalty tax does not apply to earnings that are only taxable because the account beneficiary’s adjusted qualified education expenses were reduced by Pell grants, tax-free scholarships, fellowships, tuition discounts, veterans’ educational assistance, employer-provided educational assistance or any other tax-free educational assistance (other than assistance received by gift or inheritance), or costs used to claim the American Opportunity or Lifetime Learning tax credit. In addition, the penalty tax doesn’t apply to earnings withdrawn because the beneficiary attends one of the U.S. military academies (such as West Point, Annapolis or the Air Force Academy). Finally, the penalty doesn’t apply to earnings withdrawn if the account beneficiary dies or becomes disabled.

Example: Dave has a falling out with his daughter, who decides not to go to college. Dave liquidates her 529 account, which he funded with his own money, and uses the withdrawal to buy an expensive new car for himself. Assume the 529 withdrawal includes $8,000 of earnings. Dave must report the $8,000 as miscellaneous income on his Form 1040. In addition, he will be socked with the 10% penalty tax on the $8,000.

Section 529 plans are one of the most popular ways to save for college. But in addition to knowing the rules for making contributions, it’s important to understand how you can get money out of a 529 plan with the best possible tax outcome. If you have questions, consult with your tax advisor.

© 2017