Inside: Top 529 Plan Withdrawal Tips

Education is a basic need, and it is a fairly expensive one. But it is possible to effectively manage the enormous cost of college without hurting your pocket.  Savings accounts such as a 529 plan can help parents incur these costs and avail significant benefits. A 529 plan is a tax-advantaged savings plan which provides financial security for higher education. These plans are also known as qualified tuition plans. As per the College Savings Plan Network, 529 savings plans accounted for a balance of $352.4 billion in assets by the first half of the year, hitting an all-time high in 2019. The year-on-year growth of the fund is fuelled by its advantages such as tax deductions, tax-free money growth as well as withdrawals, provided these funds are used for qualified education expenses. 

However, the realization of these advantages depends on how the funds are withdrawn from a 529 plan. Here are some tips that investors can use to ensure they withdraw aptly while maximizing savings and tax advantages.

1. Assess your qualified expenses and follow withdrawal rules

The most important tip to remember for a 529 investor is that the amount you withdraw from the plan will influence the plan’s advantages. Typically, a 529 plan only provides tax-exemption for withdrawals which are utilized for qualified educational expenses such as tuition fees, college fees, boarding, books, supplies, computer and internet access, special need beneficiaries, as well as other costs which the college specifically lists as mandatory. These could also include enrollment or admission fee, attendance fee, etc.

However, a 529 plan withdrawal made for the sole purpose of health insurance or transportation of the student will not garner any tax advantage. In addition to this, an amount up to $10,000 is covered under tax advantages, if the money is used to pay for expenses of elementary, middle, or high school. However, if the concerned college’s fee includes these allocations, the withdrawal will be eligible for tax-deductions. Hence, it is very critical to determine the accurate value of funds required for qualified expenses so that the withdrawals are made correctly. One important thing to remember while calculating the overall qualified expenses is to subtract any tuition cost, which was used to generate an American Opportunity Tax Credit or a Lifetime Learning Credit. 

An investor who withdraws excessive funds to pay for qualified college expenses will be subject to a federal tax penalty of 10% on the non-qualified earnings (not the principal). If you withdraw excess money but need to deposit it back into the plan, you can avail the 60-day window to roll over the money in the 529 account again.

2. Apply well in advance for the withdrawal

It is always more beneficial to estimate your needs well-in-advance and apply for the withdrawal at least 7 to 10 days before the expenditure due date. This is very important since the transfer to the directed bank account can take a minimum of 3 to 5 working days. Typically, you would need to request a withdrawal online and duly submit all documents and await the transfer. Hence, to not cause unnecessary delays, the application for withdrawal must be submitted in time.

3. Explicitly analyze the year of need

It is important to critically assess the year in which you will require your 529 funds. The year of withdrawal should match the year of expenditure, otherwise qualified costs can be treated as non-qualified expenses, and their extractions can attract a tax liability. For example, if you make a withdrawal in Jan 2021 to pay for a course that your child began in Dec 2020, you will be charged with a penalty. Additionally, ensure you do not overdraw your limit for the year and instead spread it across the four years of college. You must also be careful not to take out excessively fewer funds unless your child has plans to pursue higher education or you have another beneficiary for the 529 account.

4. Scrutinize all accounts and withdraw carefully

It is possible that as a parent you may have contributed to more than one 529 plan or have funds deposited in other accounts that provide tax-benefits on education. In some cases, the child may also have contributory funds from grandparents. In all these situations, the investor needs to know the qualified expense amount required and then assess how the money will be sourced from these accounts. However, it is vital to remember certain traps here. For instance, if you end up withdrawing more than the qualified expenses, the excess amount will incur a tax penalty as being non-qualified costs. Moreover, the contributory accounts of the grandparents are not considered eligible for tax savings. Hence, they will attract a charge under Free Application for Federal Student Aid (FAFSA). 

5. Direct the fund to the right source

While making 529 withdrawals, an investor must explicitly know where the funds have to be directed. In a 529 tax-advantaged saving plan, the account provider can pay in different modes. One can either directly pay the institution, credit the money in their own account, or transfer the balance in the child’s account (given the child is of eligible age). The choice depends on the preferences of the investor, and each option can have its advantages and disadvantages.

If you allow the 529 balance to go to the educational institution or college directly, you may have financial implications and also lose hold of the money. This could have otherwise allowed you to use some of the balance for aiding purposes such as transfers, etc. In other cases, if you direct the funds to the beneficiary, it can be slightly risky as the child may not turn out to be very responsible and can misuse the 529 savings, inviting penalties. There is also a risk that you may not get the reimbursement slips since it will be difficult for the child to maintain a track of expenditure. 

Though an advantage in the latter case is that the Form 1099Q will only be named for the child and hence, the subsequent tax liability will be lower owing to a lower tax bracket. It is advisable to choose the source with utmost caution.

6. Maintain a record of expenses and file all receipts

It would not be ideal to assume that all responsibilities and cautions end once the funds are withdrawn. The process is longer than that if you aim to maximize savings. Maintain a strict record of all expenses incurred from the withdrawals. These might be needed while filing for tax returns and also if any claims need to be assessed. Also, ensure that all receipts of the expenditure are duly filed since they will be useful in auditing and tax filing situations. 

To sum it up

While 529 tax-advantaged saving funds can ease the burden of the ever-increasing educational expenditure, an investor needs to be careful and make a detailed withdrawal plan to maximize savings and minimize tax liabilities. 

If you are planning to withdraw your 529 funds anytime soon, you can seek help from professional financial advisors and sail smoothly through the process.