Here’s advice for how to ensure withdrawals from 529 college-savings plans are tax-free
Most of the attention placed on college-savings plans focuses on the benefits of investing for tax-free growth before the college years. Less attention is devoted to making withdrawals from these accounts when the college invoices arrive.
To realize tax-free withdrawals, there are rules that need to be followed — some of them tedious.
These plans – which held more than $480 billion at the end of 2021 – are labeled Section 529 Qualified Tuition Plans by the IRS, but qualified expenses are broader than just tuition, books and fees. Room and board qualify, even if the student lives off-campus. A computer, if it is considered necessary to complete the student’s academic work, is also a qualified expense. (Note that some people own Coverdell Education Savings Accounts which have similar but not identical rules to 529s).
When the student, who is usually the beneficiary of a 529 account, has bills for any qualified expense, those bills may be paid directly via check from the 529 account to the college, or withdrawals can be made payable to the student or the parent/account owner. Withdrawals must be made during the calendar year that the expense was applicable. If you have tuition due soon for the fall quarter or semester but don’t make the withdrawal from the college savings account until January, even though it is the same school year, it’s a different tax year.
Up to 100 percent of qualified expenses can be covered by college savings account withdrawals. However, people who qualify for tax credits — like the American Opportunity Tax Credit (AOTC) or the Lifetime Learning Credit (LLC) — should not use account withdrawals to cover all the costs because some of those costs will effectively be paid for by the tax credit. You can’t double-dip tax-free account withdrawals and claim the tax credits. For instance, if qualified expenses in 2022 were $15,000 but you qualify for $2,500 from the AOTC, then the best practice is to withdraw $12,500 from the college savings account. If you withdraw $15,000 from the 529 account and also claim the tax credit, some of the 529 account withdrawal could be considered non-qualified and subject to taxes.
Typically, it is cleanest to have the student pay the expenses and receive the 529 account withdrawals. The IRS has been known to be fussy about parents/account owners paying the expenses and directing the account withdrawals to themselves, although this is allowed. It is also possible to have the account custodian send a check directly to the college.
Room-and-board checks also could be made payable directly to the college, but many students move off campus after the first year. In that case, room and board continues to be a qualified expense, up to a limit. The college is required to identify an off-campus living estimate in its cost of attendance calculation. Account withdrawals are considered qualified only up to this amount. For instance, for the 2022-2023 school year at the University of Washington in Seattle, the amount for rent, utilities and food is $16,068. Keep in mind that this is a 9-month figure applicable to the school year. Housing costs for study abroad programs also follow this rule. If the student is enrolled with at least a half-time credit load, the housing and food costs, up to the university-defined limit, are a qualified expense.
It is a best practice to keep all invoices for qualified expenses and to make 529 account withdrawals in the same amounts as the invoices. That way, if the IRS has any questions about the expenses, they can be easily matched.
If a student has the good fortune to have leftover money in their college savings accounts after graduation, there are still some options for maintaining tax-free growth of the investments. Excess account balances in 529 accounts could be kept for later use (graduate school, re-education at a vocational school program, etc.) by the original beneficiary. They could even be retained by the original account owner until the beneficiary has their own children and then switch the beneficiary to the third generation. Leftover amounts in 529 plans also can be transferred to another relative, keeping their tax-free character. And, as of Jan. 1, 2019, 529 account balances can be used to pay student loans, up to $10,000 total.
There are enough pesky rules and needed coordination with your tax return that some people have chosen not to utilize college savings accounts. If the student is already close to the date of use, meaning there may not be much build-up of tax-free growth on new contributions, then the juice might not be worth the squeeze. For proactive families with the capacity to save early and ongoing for college, the tax benefit may be large enough to offset the account management headache.
