avoid costly college savings plan withdrawal mistakes

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If you have a soon-to-be high school graduate for whom you’ve been diligently stashing cash in a college savings plan for, you might be wondering the best way to start withdrawing funds. Class enrollment is only a few months away, and now is the time to have a plan in place.

Unfortunately, because of the complexity of the 529 plan laws, there are a lot of potential traps out there that can trip you up. Although we have helped clients successfully navigate through them in the past, it’s a little scary to see how easy it is to make a costly mistake. With that in mind, here’s a list of several common traps from well-known college savings plan expert and CPA, Joe Hurley:

Don’t withdraw too much

“Withdrawals from a 529 plan are tax-free to the extent your child (or other account beneficiary) incurs qualified higher education expenses (QHEE) during the year. If you withdraw more than the QHEE, the excess is a non-qualified distribution. You or your beneficiary—you get to choose who receives the money—will have to report taxable income and pay a 10% federal penalty tax.”

So it’s important to track your expenses, and know which ones qualify for QHEE status. Generally speaking, money spent on tuition, fees, books, supplies, equipment, and the additional expenses of a “special needs” beneficiary are qualified. And QHEE also includes a limited amount of room and board for students who are pursuing a degree on at least a half-time basis. Importantly, here are a list of expenses that are not qualified:

“Insurance, sports or club activity fees, and many other types of fees that may be charged to your students but are not required as a condition of enrollment; a computer, unless the institution requires that students have their own computers; transportation costs, repayment of student loans, and room and board costs in excess of the amount the school includes in its ‘cost of attendance’ figures for federal financial aid purposes” are all not qualified. And as for room and board, “if your student is living off campus, ask the financial aid department for the room and board allowance for students living at home with parents, or living elsewhere off campus, as the case may be. If the student is living in campus-owned dormitories, the amount you can include in QHEE is the amount the school charges for its room and board.”

Another thing to be wary of is the rule on “double-dipping.” In a nutshell, the law says you cannot take both the educational tax credits (such as the American Opportunity credit or the Hope credit) and QHEE status on the same expenses. It’s one or the other.

“What can you do if you receive a distribution check from your 529 plan only to discover after speaking with your accountant that you’ve taken too much? If you are still within the 60-day rollover window, you can take the excess and roll it into a different 529 plan so that amount is no longer treated as a distribution, provided you have not rolled over that child’s 529 account within the prior 12 months. If you are outside the 60-day window, but within the same calendar year, you can look to prepay next year’s expenses to increase this year’s QHEE. If you discover the excess withdrawal after year-end, there’s not much you can do about it. The good news is that if the non-qualified distribution is caused by the tax-credit adjustment described above, the 10% penalty is waived.”

Don’t take money in the wrong year

“Although you will not find this rule explicitly stated anywhere in the IRS’ publications or tax forms, the withdrawals you take from your 529 account must match up with the payment of qualifying expenses in the same tax year. If you withdraw the 529 money in December for a tuition bill that isn’t paid until January, you risk not having enough QHEE during the year of withdrawal.”

So the key here is to plan ahead. One way to do this is to have an EFT link setup from the 529 account to your bank account, so that withdrawals can be processed quickly. Joe says that another way to address it is to request “that the distribution from the 529 plan be sent directly to the school bursar.”

Don’t have the payment sent directly to the school (in some cases)

Although Joe sometimes recommends that clients have 529 plan withdrawals sent directly to the school, that plan can also backfire if you aren’t careful.

“Requesting the payment directly to the school could be a mistake if you are not sure how the school treats the 529 money in its financial-aid process. Schools often receive checks for outside scholarships won by their students, and they will typically reduce the student’s federal and school-based grants by an equivalent amount.”

“You would not want the school viewing the 529 money the same way it views a scholarship and reducing your child’s financial-aid package. Check with the school first and confirm its policy with respect to funds received directly from a 529 plan. You always have the option to request the distribution be made payable to you or your student. It then becomes your responsibility to pay the school.”

 

You can read Joe’s entire article here, or just call us. We are here to help our clients avoid these, and other costly financial mistakes.