Congratulations! Your child is months away from graduating high school and going off to college. Better yet, for the last 18 years, you have diligently saved money in a 529 Plan, noting the many benefits that 529 Plans offer over other college saving strategies.
You have done a fantastic job saving for this occasion, and now it is time to think about how you will tap into your 529 Plan savings. This article outlines some tips to make your life as stress-free as possible as you transition into becoming a college student parent.
Which Expenses Your 529 Plan Covers
Before figuring out how to take your distributions from a 529 Plan, you need to know which expenses are considered eligible. For a distribution from your 529 Plan to remain tax-free and penalty-free, the expenses must be regarded as Qualified Higher Education Expenses (QHEE).
QHEE includes tuition, mandatory expenses (e.g., lab fees and required software), required books, supplies, and equipment. The SECURE Act added the ability to repay up to $10,000 in student loans. You can see a longer list of QHEEs here.
Room and board is also considered an eligible expense but has some restrictions. For starters, your child must be enrolled at least half-time. Also, if your child lives in campus-owned dormitories, the school’s charges will be considered a QHEE. However, if a student decides to live off-campus, the QHEE will be limited to the school’s amount for on-campus room and board.
You will be responsible for keeping track of your expenses to ensure they remain tax-free and penalty-free in the event of an audit.
How Scholarships Impact Your 529 Plan Savings
What if your child receives a scholarship to go to school? There is an exception for QHEEs for students who receive scholarships. In this case, you are allowed to withdraw assets from your 529 Plan, up to the scholarship amount, penalty-free. However, you still need to pay income taxes on the earnings. Alternatively, you can use the funds to pay for graduate school or use one of the best features of the 529 Plan ─portability─ to transfer the beneficiary to another child or direct relative. You can even decide to hold it and set it up as an Education Trust for future generations!
529 Plans in Conjunction with FAFSA
Before taking any 529 Plan distributions, understand how they affect a FAFSA application. 529 Plan assets owned by the parent are included on the FAFSA application, meaning they will affect the amount of aid a student receives. However, 529 Plan assets held by grandparents or other relatives are not considered and will not affect the FAFSA until distributions are made. Therefore, in most instances, we recommend not taking distributions until the FAFSA application has been filed and financial aid has been received.
We always recommend consulting with your financial planner to determine the most efficient way to take distributions from your 529 Plan.
The Logistics of 529 Plan Distributions
To take a distribution, you need to alert the 529 Plan (either directly or through your financial advisor) of the amount you want to distribute and to whom the payment will go. Logistically, it is generally easier to distribute an entire semester’s worth of costs at one time rather than after each expense is incurred.
It’s important to note that you can not re-deposit money into a 529 Plan. All distributions are final. Therefore, if you realize you withdrew too much money from your 529 Plan, you must find other qualifying expenses to avoid the tax penalty, or you may rollover the distributions to a new 529 Plan. This is time-sensitive. You only have 60 days from the original distribution to rollover excess distributions.
Tax Treatment for 529 Plan Distributions
As you know, 529 Plans offer tax-free growth and penalty-free distributions if used for QHEEs. However, taking distributions will generate a tax form called the 1099-Q. 1099s report interest income, independent contractor income, and IRA income.
If your 1099-Q is less than your QHEEs, nothing needs to be reported on the actual tax return. However, you cannot double-dip. For example, you cannot use education expenses incurred as QHEEs, then use those same expenses again for education tax credits like the American Opportunity Credit and Lifetime Learning Credit.
You can designate three different entities to receive the distributions:
- The Account Owner (presumably you)
- The Account Beneficiary
- The College/University
Checks payable to the account owner trigger a Form 1099-Q in their name and Social Security Number. The owner must provide evidence of the QHEEs to the IRS to justify excluding the distribution from the tax return.
Checks payable to the student trigger a Form 1099-Q in the student’s name and Social Security Number. If the qualifying expenses exceed the 1099-Q, the distribution is tax-free and not reported on the tax return.
Checks distributed directly to the college will not trigger a Form 1099-Q. However, some schools treat these 529 Plan distributions as outside scholarships. These funds can potentially reduce the amount a student receives from need-based financial aid packages. That is why you must be aware of how colleges treat 529 Plans before distribution.
The transition from saving for college to paying for college is very nuanced and involves planning. You need to understand three critical areas:
- Which expenses are eligible for reimbursement?
- Who should receive the payments?
- How will your choices affect your taxes?
Eduction planning is an important part of your overall financial plan. We strongly encourage you to consult with your Access Wealth advisor about the best ways to manage your 529 Plan distributions.