After years of saving, your child is finally off to college and you wonder how 18 years have gone by so fast. Ideally, you’ve taken advantage of long-term, tax-free compounding discussed in our college savings strategies blog(http://www.thorinvestment.com/saving-for-college/) and have built up nice gains in the college accounts. Savings in a state-sponsored Qualified Tuition Program, or 529 Plan as they’re commonly known, have grown tax-free and are now ready to be spent completely tax-free if you follow a few rules.
This is also a good time to rebalance investments in the 529 account if you haven’t already done so. If you started saving early, your investment choices should have been fairly aggressive. These investments should be reallocated to less risky fund choices as you get ready to withdraw the money. Ohio’s 529 Plan, where we are based, allows the account owner to reallocate investments twice a year.
Keeping Withdrawals Tax-free
Tuition, room and board qualify. Withdrawals for 529-eligible higher education expenses are tax-free. Tuition, naturally, is eligible, as are room and board if your student is enrolled at least half-time. Other qualifying expenses include mandatory fees, computer equipment and related services, and books and supplies required for attendance.
Timing is critical. To be tax-free, the withdrawal must be made in the same calendar year as the expenses are paid. Keep in mind that the academic year is not the same as the calendar year.
Off-campus housing counts. If your student moves off campus and rent is paid to a landlord rather than to the university, you can make a withdrawal to pay the rent. To keep the distribution tax-free, the amount should be no more than the university’s published room and board rates, typically found on the school’s website under Total Cost of Attendance. Or call the school’s financial aid office.
Treatment of non-qualified withdrawals
Beware of taxes and penalties. The earnings on any withdrawal used to cover non-qualified expenses will be included in your ordinary income for federal and state income taxes, plus the earnings will be subject to a 10% penalty. Note that transportation costs, parking fees, student health insurance and repayment of student loans are not eligible expenses for 529 purposes.
Scholarships are an exception. If your student-scholar or student-athlete receives a scholarship that results in excess funds in your 529, you can withdraw up to the amount of the scholarship without incurring the 10% penalty. The earnings are still subject to income tax. If your student has other qualified expenses that the scholarship doesn’t cover, you can use your account to cover these costs.
Consider tax-free options for unused funds. Raiding your 529 account for non-qualified expenses comes with the tax and penalty costs mentioned previously. There are better options if you have leftover 529 funds. Since 529 accounts have an indefinite life-span, you can hold onto the account for your child’s continuing education programs such as graduate, law or medical school. Another option is to transfer the 529 funds to another beneficiary. The new beneficiary/recipient must be related to the original beneficiary in one of these ways: sibling, stepsibling, cousin, parent, grandparent, niece or nephew. Yet another option is holding on to the account for the higher education costs of future grandchildren.
Pay expenses directly or indirectly
Direct payments from 529 to school. The cleanest way to disburse the money from a documentation standpoint is to request that the 529 program pay the school directly; however, note that the payment will be made via check, so allow at least two weeks prior to the bill’s due date for the payment to be processed and received by the school.
Reimbursements to parent or beneficiary. If you choose this method, remember to keep itemized receipts of the expenses to support the qualified withdrawal, and process the disbursement in the same calendar year as the expense.
Selling investments in the account. If the account includes more than one investment fund, the plan will sell the investments in equal proportions to raise cash. You must instruct the plan if you want the cash to come from a specific investment.
Expect to receive two forms at tax time: Form 1099-Q, from the 529 plan, reports the total of all withdrawals you made during the year; and Form 1098-T, from the college or university, reports qualified educational expenses.
There are several higher-education tax breaks available, including the tuition-and-fees deduction, the American Opportunity Tax Credit and the Lifetime Learning Credit. Qualified expenses paid for with 529 funds are not eligible for these tax breaks, because you have already enjoyed the double benefit of tax-free investment growth and tax-free withdrawals. But, if your 529 savings fall short of covering all qualified higher-education costs, you can take advantage of these tax savings if you meet certain income tests. The deduction and tax credits phase out at the following income levels:
- Tuition and Fees Deduction. Modified adjusted gross income (MAGI) between $65,000-$80,000 (single) and $130,000-$160,000 (married filing joint). Note that Congress has not renewed this deduction for 2017, but still could do so and make it retroactive.
- American Opportunity Tax Credit. MAGI between $80,000-$90,000 (single) and $160,000-$180,000 (married filing joint).
- Lifetime Learning Credit. MAGI between $55,000-$65,000 (single) and $110,000-$130,000 (married filing joint).
The definition of qualifying expenses is different for these tax breaks than for 529 plan withdrawals. For instance, room and board qualify for tax-free withdrawal from a 529 plan but do not qualify for tax deductions and credits. There are lots of complexities in tax benefits for higher education, so be prepared to do some research or consult a tax specialist.