by Charissa Anderson, CFP®, CDFA
Senior Vice President
Portfolio and Wealth Management
When it comes to saving for college, 529 accounts are a popular choice. These tax-advantaged savings plans are designed to help families set aside funds for future education expenses. You can choose from various investment options and enjoy tax-free growth and withdrawals for qualified education costs.
While these accounts offer significant benefits, it’s important for account holders to be aware of potential pitfalls when withdrawing funds. Missteps can result in taxes, penalties and other financial repercussions.
NonQualified Withdrawals
One of the most significant pitfalls is withdrawing 529 account funds to use on nonqualified expenses; doing so subjects you to income tax and a 10% penalty on the earnings portion of the withdrawal.
To avoid this pitfall, make sure to understand what qualifies before making a withdrawal and maintain records of your invoices and receipts. For example, qualified expenses include tuition at a college or
trade school, books, supplies and apprenticeship-related expenses.
Room and board, both on and off campus, are also a qualified expense if the student is enrolled at least half time. Common nonqualified expenses include transportation, health insurance and fees for sports
or club activities.
Timing of Withdrawals
Timing is a key factor when withdrawing funds from a 529 account. Withdrawals should be made in the same calendar year the expenses are incurred, regardless of the academic year. Failure to align these withdrawals and expenses within the same year could result in nonqualified distributions.
This risk is particularly acute with second semester tuition bills that arrive in December and are not payable until January. To avoid this risk, account owners can ensure proper matching by requesting the distribution from the 529 be paid directly to the college.
Tax Incentives and Coordination Rules
Families cannot double-dip by using a 529 plan distribution and claiming the American Opportunity Tax Credit or the Lifetime Learning Credit for the same expenses.
These coordination rules stipulate that if a 529 plan distribution is used for qualifying education expenses, the amount of those expenses must be reduced by any tax-free educational assistance or credits received.
Additionally, while the federal government allows up to $10,000 per year to be withdrawn from 529 accounts for K-12 tuition expenses, not all states, including Oregon, have conformed to this change. In states that have not adopted this change, using funds for K-12 expenses could result in the prior state tax benefit being recaptured, along with potential taxes or penalties on earnings. It is important to review the specific rules of the state where the 529 plan is located before making any withdrawals.
In conclusion, a 529 account is a powerful tool for funding education, but it requires careful planning and coordination to avoid unnecessary taxes and penalties. Fortunately, if you inadvertently withdraw too much money from a 529 account, you have 60 days to recontribute the excess funds back into a
529 plan for the same beneficiary to avoid taxes or penalties on the overwithdrawal, essentially allowing you to “correct” the withdrawal.
Ferguson Wellman, Octavia Group and West Bearing do not provide tax, legal, insurance or medical advice. This material has been prepared for general educational and informational purposes only and not as a substitute for qualified counsel. We believe the information provided is from reliable sources but should not be assumed accurate or complete. You should consult qualified professionals to understand how this information may, or may not, apply specifically to you.