Understanding the tax rules and keeping track of expenses are key parts of the process.
Question: We've contributed to a 529 account for our son for years. This fall he'll be a college freshman, and we'll be dipping into the account for the first time. How do we use it to pay for his expenses?
Answer: Watching your child graduate high school and enter college can be a source of pride for any parent, but sooner or later you're bound to face the cold realization that hefty tuition bills and other college-related expenses will soon need to be paid. Fortunately for you, you've planned for this moment by putting funds aside in a 529 college-savings account. (Morningstar experts shared their own college-savings tips in this recent article.)
Aside from tax-free growth and, in some cases, a state income tax deduction on contributions, 529 accounts allow for tax-free distributions to pay qualified college expenses, which include tuition and fees, books, supplies, and equipment required for attendance. (Additional expenses for special needs students also qualify.) Room and board are also qualified expenses, provided the student is enrolled at least half time as defined by the school.
Coordinating Payments and Withdrawals
When it's time to start paying those college bills you'll need to contact your 529 plan administrator and ask for a distribution, which may be paid to the account holder, to the account beneficiary (the student), or, in some cases, directly to the school. At the end of each calendar year in which a disbursement is made, the plan will issue a Form 1099-Q for federal income tax reporting purposes. If the disbursement is made to the account holder, he is issued the 1099-Q, whereas if it goes to the beneficiary or to the school, the beneficiary is issued the form.
For tax purposes, 529 assets should be distributed during the same calendar year in which they are used, but these two events can happen at any time within the year. For example, you could take a 529 distribution in January even though the funds won't be needed until that fall, or you could make an out-of-pocket payment for eligible expenses early in the year and then reimburse yourself several months later by withdrawing 529 assets. Keep in mind that there will be a lag between the time you request the money and the time it is paid out, so if you need it for a fast-approaching tuition bill, get your request in ahead of time (plan documents should give you some guidance regarding how long to allow for distribution requests).
Also, be careful not to withdraw more than is needed from the 529 account in a given year or you could end up paying taxes on the excess amount. If the amount withdrawn for the year exceeds the amount of qualified expenses paid on the student's behalf, the portion of the difference that consists of investment earnings is subject to taxes, with a 10% penalty added to the amount. For example, if you withdraw $20,000, but the student only incurs $18,000 in qualified expenses, you'll pay taxes on the earnings portion of the $2,000 excess withdrawal plus a 10% penalty. If you took a larger-than-necessary 529 withdrawal because the student received a scholarship or grant, any excess distribution is still subject to taxes on the investment-earnings component, but the penalty is waived. Also, if you plan to use a college-related federal tax break, such as the American Opportunity Tax Credit, make sure you exclude from your 529 qualified expense calculation the college expenses counted toward that federal tax break to avoid double-dipping. Any taxes owed are the responsibility of the person receiving the disbursement (and thus the 1099-Q). Finally, keep in mind if you take a larger-than-necessary withdrawal, you cannot simply return the amount you don't need to the 529 and avoid the taxes and penalty; any kind of overwithdrawal will be taxed.
If using 529 accounts from multiple account holders for the same beneficiary--say you and your child's grandparent both plan to withdraw 529 assets to cover expenses in the same year--make sure you coordinate distributions so that neither account holder takes out too much and gets hit with taxes. Also, if you know in advance that an unqualified withdrawal will be made--perhaps the student is graduating and there are excess funds that can't be used by another family member, or the funds are needed for a noncollege purpose--it may make sense to have them distributed to the beneficiary, assuming his tax rate is lower than that of the account owner.
Hold On to Your Records
According to the Internal Revenue Service, qualified expenses for room and board are limited to the amount used in the school's cost of attendance calculation for federal financial aid or the actual amount charged for living in school-owned or school-operated housing, whichever is higher. So if the student lives off-campus and pays $10,000 for room and board but the school charges $8,000, the account holder may only withdraw $8,000 in 529 assets for that purpose.