How to do 529 distributions

By May 29, 2021June 10th, 2021Investing, PFA Ponderings

May 29th is a significant day to me in several ways. First, it marks the day that my parents got married. 11 months later, here I was.  It’s also 5/29. Not a bad day to go through some of the “technical” parts of taking distributions from 529 plans!

Account owners can withdraw 529 plan savings tax-free to pay for costs related to attendance at in-state, out-of-state, public and private colleges, universities or other eligible post-secondary educational institutions. Since the Tax Cuts and Jobs Act of 2017, qualified 529 plan expenses also include up to $10,000 per year in K-12 tuition expenses. But be careful!  If you don’t follow important 529 plan withdrawal rules, you may be subject to taxes and a 10% penalty on growth of the 529.

It’s up to the 529 plan account owner to calculate the amount of the tax-free distribution and how they want to receive the funds. Taking the money from the 529 plan is usually straightforward, but there are ways of making it truly easy.

Want to make sure you don’t pay taxes and penalties?  Follow these four steps when taking 529 distributions.

Step 1 – Calculate your Qualified Higher Education Expenses (QHEEs)

As a 529 plan account owner, you can always take out ANY amount from the 529 accounts.  However, only qualified distributions will be tax-free. The earnings portion of any non-qualified distributions must be reported on the account owner’s or the beneficiary’s federal income tax return and is subject to income tax and a 10% penalty.

When you’re calculating the QHEEs, you’ll first want to add up:

  • College expenses, including tuition, fees, books, supplies, and equipment. You can tack on the cost of computers and room and board if the student is enrolled on at least a half-time basis
  • K-12 tuition and fees (up to $10,000 per year)

Next, subtract any tax-free educational assistance, including:

  • Tax-free scholarships
  • Educational assistance through a qualifying employer program
  • Veteran’s educational assistance

Next, subtract the amount of any expenses used to justify the American Opportunity Tax Credit or Lifetime Learning Tax Credit (LLTC).  Importantly, it’s not the value of the credit you need to subtract, it’s the amount you used to get the credit.

Example:  Jane is planning on using her son Edgar’s 529 plan assets to pay for his semester at college.  His expenses added up to $10,000 for the semester, and he received a $2,000 tax-free scholarship which went to defray that.  Jane calculated that she could receive the American Opportunity Tax Credit of $2,500 based upon what she spent for Edgar’s education.  The AOTC gives a dollar-for-dollar credit for the first $2,000 and 25% of the remaining amount, up to a total maximum credit of $2,500.  Thus, a total of $4,000 is the amount she used to get the credit and that, along with the scholarship are removed from the tuition and fees when calculating QHEEs.  This makes the total amount she can withdraw as a qualified distribution from the 529 plan $10,000 – $4,000 (the amount used to qualify for the AOTC) – $2,000 (the scholarship) = $4,000.  If Jane took the full $10,000 from the 529 for the year, $6,000 would be considered a non-qualified distribution.

When there is a non-qualified distribution, the earnings portion of the distribution is included in the 529 owner’s taxable income, along with a 10% penalty, with some exceptions.

In the example above, if the 529 balance consisted of 10% earnings and 90% cost basis, the non-qualified distribution of $6,000 would include $600 of earnings taxable to Jane.  Some, but not all, of that $600 would be subject to the 10% penalty.  The portion allocated to the amount covered by a scholarship is exempt from the 10% penalty.

Other exceptions to the penalty include:

  • Tax-free educational assistance
  • Receipt of education tax credits
  • Attendance at a U.S. Military Service Academy
  • Death or disability
  • Return of excess distributions

Step 2 – Figure out the best time to take the distribution

You should take 529 plan distributions during the same year in which you paid for the qualified expenses. For example, do not include second semester tuition expenses that you paid for in December of the previous year.

Step 3 – Decide which 529 plan account to withdraw from

If the beneficiary has more than one 529 plan, consider withdrawing from a parent-owned 529 plan account first. Funds withdrawn from a 529 plan owned by a grandparent (or an uncle!) count as student income on the Free Application for Federal Student Aid (FAFSA) and may hurt the student’s eligibility for need-based aid.[1]

 

Step 4 – Complete a withdrawal request

Usually, withdrawals are easily done.  Generally, 529 investment providers have online platforms where you can register and access your account, including making distribution requests.  There are also generally 1-800 numbers you can call, and if you’re into paper, there are also usually forms you can complete.

You’ll generally have the option of making the distribution payable to yourself as the account owner, to the institution or school, or to the beneficiary.  If you’re making qualified distributions, it shouldn’t matter much.  You can reimburse yourself for out-of-pocket payments you’ve made during the year, and frequently people wait until December to do so once they’ve identified all their QHEEs.  If you are taking a non-qualified withdrawal, it may make sense to have the distribution made out to the beneficiary if he or she will be in a lower tax bracket.

Either way, a 1099-Q will be issued.  This form will NOT give information on how much of the distribution is qualified, but it will calculate how much of the distribution is related to earnings and basis.

529 plan funds can also be rolled into another account with the same beneficiary, or into a sibling’s 529 plan account.

Being careful to limit distributions to only QHEEs is the most challenging part of taking distributions from 529 plans.  Other than that, the process should be simple and straightforward.  Happy 5/29!

[1] A new FAFSA form, which is scheduled to go live on October 1, 2022, apparently will not require students to report cash support. So, any distributions that a grandparent takes from a 529 plan in 2021 or later (due to prior-prior reporting) will not be included in the student’s financial aid calculations on the FAFSA. If you have to fill out the CSS Profile form, however, this does NOT change.