Tips to help your 529 plan pay off after years of saving

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Q:

My son, and only child, is starting college next year, and my husband and I have been saving for years in a 529 savings plan to help make his college experience all that it can be. His freshman orientation starts at the end of August, so it’s go time. Is withdrawing from the 529 plan to pay for tuition as simple as withdrawing from the account and sending it to the college? If I don’t get it right, it could mess things up for him, and for my husband and me, because we want those withdrawals to be tax-free and avoid any nonqualified withdrawal penalties.

A:

First, congratulations. It’s the start of an exciting new chapter for your son but also for you and your husband, especially as he is your only child. Sending your child off to college can be bittersweet (we’ve been there, too!). However, there are financial and lifestyle considerations beyond college tuition payments that you and your husband want to begin considering right now as soon-to-be “empty nesters.” Here are some strategies to help you get started.

Now, on to your question about steps to follow when withdrawing from your 529 savings plan for the first time. There are a number of items, so we will give you some of the key ones.

Make withdrawals and payments in the same year

As the account owner of your 529 college savings plan, you want to ensure your withdrawals are considered qualified withdrawals and remain tax-free at the federal and state levels. One of the major advantages of a 529 savings plan is the federal income tax benefits on qualified expenses, which include tuition, fees, books and certain room and board costs.

To help ensure the 529 plan withdrawal is tax-free, it's best practice to make your tuition payment and take the distribution in the same calendar year. This synchronization is crucial because mismatched timing can lead to nonqualified withdrawals, which may be subject to federal income tax and a 10% federal tax penalty on the earnings portion of the distribution. Additionally, some states have specific state tax treatment rules that could impact your tax deductions or credits. We recommend that you work with a qualified tax professional and financial advisor to get the timing right and to understand any potential state tax implications.

It's easy to make a 529 withdrawal and tuition payment in the same year for the fall/winter semester because payment is typically due in August or September. The spring semester is a different story because the payment is usually due shortly after New Year's. That means the withdrawal and the payment should happen at least in December, right in the middle of the holiday season, so plan for it!

If you need to use your cash reserves to make a payment on time in early January, then you can withdraw funds from your 529 plan later in January and reimburse yourself. Just remember to save the documentation of the entire transaction for Uncle Sam. Keeping accurate account information and records is essential in case the IRS requests proof that the distributions were used for qualified higher education expenses. You will receive an IRS Form 1099-Q from your plan administrator, which reports distributions from your 529 account.

Whatever you do, pay the tuition expense on time; otherwise, your child – the designated beneficiary of your 529 plan – could be dropped from required classes. Depending on where he is in his college years, this could result in his not graduating on time and needing an extra semester, which could mean additional college expenses. Delays in payment could also affect his eligibility for federal student aid.

Ways to make a payment

Let's talk about another critical component of using a 529 plan: ways to make the payment.

Before paying the tuition, your plan's program description, website or administrator may have an online portal where you can usually select how you want to make a distribution.

1. You may choose to deposit the distribution electronically to your bank account. If so, talk with your 529 plan administrator to help ensure your bank account is linked to your 529 plan. You may need your account number and other account information to set up the transfer.
2. You also may be able to make a payment toward tuition directly from the 529 account to the college. This option can simplify the process but requires accurate contact information for the school's bursar or financial aid office.
3. When the payment is made using either of these options (and there are other options), you should consider making the request for the withdrawal at least two weeks or more before the tuition deadline to allow for enough time for it to be posted. Be sure to use the correct withdrawal request form provided by your 529 plan to avoid any processing delays.
4. A college may allow payment to be made through their own online portal. If the college allows for a credit card payment, be forewarned that there can be a pretty hefty service charge added to the tuition cost. See if there is an eCheck option, which can be free of charge, to avoid this service fee.
5. You can first make the payment from your cash reserves and then take a 529 distribution later in that same calendar year to reimburse yourself – just remember to document the transactions. This method can be useful if timing is tight, but keeping thorough records is essential to prove that the funds were used for qualified expenses.

In addition, consider reviewing your investment options within the 529 plan as your child approaches college age. Some account owners may choose to adjust their investment strategy to help reduce risk and preserve funds needed for imminent tuition expenses. It's also a good time to think about any future contributions you may want to make to your 529 plan, as contribution limits can affect your planning.

If you haven't already, familiarize yourself with your plan's program description, which outlines important details about qualified expenses, nonqualified expenses and how to handle distributions. Understanding these can help you avoid making a nonqualified withdrawal, which could result in taxes and penalties.

A 529 is good for off-campus rent too

Your son may be living on campus in his freshman year, but come sophomore year, he and his buddies may want to rent an apartment near campus. That’s a very popular option these days and guess what? Your 529 plan can help pay for that too. Rents can be steep in college towns, but your 529 plan can pay up to the maximum fees charged by the school for on-campus housing.

Just remember that the 529 withdrawals and payments for rent need to occur in the same calendar year. Because the academic year flows into the next year, you can’t withdraw the full 12 months’ rent at once. Again, document all qualified expense payments using your 529 distributions.

In addition to rent, your 529 funds can be used for other qualified expenses such as books, supplies and required equipment. It's essential to consult the 529 plan's program description for detailed information on what expenses qualify.

If your son decides to live off-campus, make sure the rent doesn't exceed the allowance for room and board outlined in the college's cost of attendance figures. This information can usually be obtained from the college's financial aid office. Exceeding this limit could cause a portion of your withdrawal to be considered a nonqualified withdrawal.

Additionally, if you're considering using 529 funds for K-12 tuition expenses, be aware that federal law allows up to $10,000 per year to be withdrawn for K-12 tuition at public, private or religious schools. However, state tax treatment of such withdrawals can vary, so check with a tax professional about potential state tax implications.

Final notes

Some final notes about using your 529 plan. Your student must be enrolled in the college or university for 529 distributions to be used to pay qualified college expenses. That means that they should have a student ID as documentation. Expenses that occur before this, such as college application fees and accepted student trips, don’t meet this criterion.

Additionally, student health care (which may appear as part of your tuition bill) is not considered a qualified expense, nor are flights or travel to get to college. Again, using your 529 plan funds for nonqualified expenses could result in a nonqualified withdrawal, subject to federal income tax and a 10% federal tax penalty on the earnings portion. So, it's crucial to understand the rules and follow them consistently so you can avoid unexpected tax liabilities.

Keep in mind that some states may offer state tax deductions or credits for contributions to a 529 plan. However, if you take a taxable withdrawal, you may have to recapture those state tax benefits. Be sure to consult with a tax professional to understand your state's specific tax treatment.

Also, consider that 529 savings plans are not the only education savings accounts available. For example, a Coverdell education savings account offers another way to save for educational expenses, including K-12 tuition. However, contribution limits for ESAs are much lower, and there are income restrictions. It's important to evaluate which investment option best suits your family's needs.

If you find that you have excess funds in your 529 plan after covering all qualified expenses, you might consider transferring the funds to another family member for their education expenses. Alternatively, recent changes in legislation may allow you to roll over unused 529 funds into a Roth IRA for the beneficiary, subject to certain limitations starting in 2024.

We hope you’ve found this information helpful

Remember that any financial guidance must be adapted to your unique circumstances, so consult your financial planner. In the meantime, keep those questions coming!