You’ve been saving for this moment since your child was born. It’s time to use their 529 savings to pay for college! (A 529 plan is an investment account with tax advantages that can be used for education savings.) Just like saving for college took planning, distributions from your 529 will require some planning to use these funds for qualified tax-free expenses and to avoid mistakes that could cost unexpected taxable income and penalties.
To begin the process, you, the plan owner, will authorize the distribution on your child’s behalf online or by completing a paper distribution form. To ensure the distribution will be tax-free, the expense needs to be a qualified education cost required for your child to enroll or attend a college or university. These qualified expenses include:
- Tuition and fees (but not parking fees) billed by the college
- Books, supplies, and equipment
- Expenses for special needs services incurred in connection with enrollment or attendance
- Expenses for room and board if your child is enrolled at least half-time and if the cost is less than the greater of: the school’s determined allowance for room and board for federal financial aid purposes OR the actual amount charged if the student is residing in school-owned housing
- A computer or peripheral equipment, computer software, or Internet access, if it’s to be used primarily by your child for educational purposes during any of the years your child is enrolled
- Expenses required for an apprenticeship program that is registered and certified with the Secretary of Labor under section 1 of the National Apprenticeship Act
- No more than $10,000 paid as principal or interest on qualified student loans of your child
- Expenses for no more than $10,000 of tuition for an eligible elementary or secondary school
With most plans (including the TN Stars 529 plan), the distribution will be made to you via direct deposit, to you via check, to your child via check, or directly to the college or university. The 529 plan will report the distribution to you and the IRS by issuing Form 1099-Q, using either your Social Security number or your child’s SSN, depending on whether the distribution is paid to you, or your child (or their institution).
The timing of distributions from your 529 must match the tax year in which the qualified expenses were paid, so you can’t make a distribution for expenses paid the prior year. Make sure to keep your receipts as backup. Also, for spring tuition payments, college invoices may be sent in December and are due in January, so be sure your 529 distribution matches the tax year for which you paid the bill. Distributing the 529 check directly to the college can alleviate this timing issue.
If you qualify for the American Opportunity Tax Credit (AOTC) and have 529 savings, you can use 529 funds and claim the AOTC, but you must coordinate these two tax savings benefits, because “double dipping” is not allowed.
If your child was awarded a scholarship, you could make 529 distributions, but you will likely owe tax on the earnings portion of the 529 distribution. Fortunately, the 10% penalty is waived in this instance. If you have a high-achieving student awarded a “full ride” scholarship and your 529 funds are substantial, you may want to take advantage of this penalty-free distribution. If you are in a very high tax bracket, the distribution should be made to the child for tax purposes, though the “kiddie tax” might pre-empt any tax savings. Other options include keeping the 529 plans for graduate school, other siblings or family members. 529 plans can be handed down to the next generation – an ideal family education legacy.
If their grandparents own your child’s 529 plan, there are additional stipulations to consider if your child is also receiving financial aid. If financial aid is not an issue, then thank your parents (and have your child thank their grandparents) profusely for their foresight in saving for college!
Every situation is different, and I recommend discussing your options with your financial advisor to ensure you’re maximizing your 529 savings plan, so you can focus on helping your child succeed as they leave the nest.
Carol Lee Royer, CFP, CFA, CDFA, serves as a senior wealth strategist and senior vice president at Waddell & Associates, an SEC-registered investment advisory firm with offices in Memphis and Nashville.