529 Withdrawal Rules and How to Maximize Your Benefits

If you have a small child and are ready to sock away some of your income now, you can take advantage of a 529 Plan, also called a qualified tuition plan. Or perhaps you’ve got a child nearing college-age and you need guidance on how to make qualified withdrawals from that child’s 529.

The 529 plan, named after Section 529 of the Internal Revenue Code, is a program that enables parents and others involved in a child’s life to save money for college and other higher education expenses. Tax benefits are a key reason to use a 529 for college savings. Of course, as with any program involving taxes, read the fine print carefully and then follow the 529 withdrawal rules to maximize college savings.

Related: Are 529 Contributions Tax-Deductible?

529 distribution rules to remember

Qualified tuition plans have a lot of benefits, but there are very specific 529 withdrawal rules that parents and students need to understand before using those funds. To cover expenses using 529 withdrawal, those expenses must be essential for your education.

However, the interpretation of that guideline isn’t always obvious, and some of what the IRS deems a necessary educational expense might surprise you. For instance, your transportation expenses for getting around campus or traveling to and from your college or university don’t typically qualify for 529 withdrawals.

Attending an eligible educational institution is another requirement for using funds from college savings plans. If you select a prepaid tuition plan, that comes with greater limitations than a general 529 plan. Either type of qualified tuition plan stipulates the beneficiary use the funds at an eligible college or university.

Consider state rules for 529 withdrawals

Remember that while most 529 plans have certain commonalities, there are a few differences. Some states offer the opportunity to deduct 529 contributions from your state income tax, but you might lose this benefit if you don’t invest in a 529 within your state of residence.

Qualified vs. non-qualified expenses

To avoid getting hammered with extra taxes on your 529 earnings withdrawals, know what categories of college expenses can be funded with a 529. Here’s a quick summary of what’s typically considered a qualified 529 expense vs. a non-qualified expense.

Qualified expenses for 529 withdrawals

• Tuition (including a maximum of $10,000 annually for private K-12 tuition expenses, such as at religious schools or other private schools)
• Room and board, based on the institution’s published allowance for those expenses
• Fees (administrative fees and any other mandatory fees)
• Required textbooks for class
• Required educational supplies and equipment
• Special needs services and adaptations (such as hearing aids, ASL interpretation, and other required services based on the 529 beneficiary’s special needs)
• Computer and related technology costs (but be sure the computer is primarily for educational purposes)
• Up to $10,000 of repayment of qualified student loans. This applies to distributions made after December 31, 2018.

Non-qualified expenses for 529 withdrawals

• Transportation (even if it’s technically necessary to get to or around college, costs associated with your car, bus or bicycle don’t qualify)
• Fees for sports, athletics, other activities
• Health insurance and medical costs
• Electronics such as cell phones, or any technology that isn’t primarily for education
• Room and board, if it exceeds the school’s estimated housing cost

Mistakes to avoid in 529 withdrawals

One mistake to watch out for with 529 plans actually begins when you open the account and begin making contributions. It’s impossible to predict someone’s exact higher education costs when that point is years away, but aim for a reasonable estimate. You can avoid the problem of tax penalties for breaking 529 withdrawal rules if you don’t overfund the account in the first place.

Another issue people run into is taking out more than the maximum allowable dollar amount as dictated by the total qualified educational expenses. Even when an expense is an acceptable one for 529 plans, you can’t go beyond published numbers. Any amount beyond what the specific college deems as necessary for that category will result in penalties on withdrawals.

Check with the university to learn their estimated cost of attendance, as well as the breakdown of how much is allowable for every category, such as housing.

You should also take care to make 529 withdrawals during the same tax year (not necessarily academic year) as you pay for the qualified expenses.

A problem that can occur if your timing is off? You might end up owing taxes because this can become a non-qualified withdrawal.

Don’t forget that if you took out a prepaid tuition plan versus an educational savings plan, 529 withdrawal rules are much more stringent. If your child decides not to attend a participating college or university, this can significantly reduce the returns you’ll receive from that investment. Ideally, the beneficiary should attend a college accepted by that prepaid tuition plan to maximize the account’s value.

How to withdraw 529 funds

When the time comes to begin taking distributions from a child’s 529 plan, it’s important to pay attention to your timing as well as what you use the money for. Here’s how to withdraw money from a 529 to pay tuition and other qualifying expenses.

• Keep meticulously accurate records and receipts of all expenses you intend to pay with 529 funds.
• Calculate the total amount the student beneficiary will need for qualified expenses for the semester. Refer to the college’s published cost-of-attendance calculation for each category of expenses like room and board so you know your maximum.
• Deduct costs covered by tax-free educational assistance programs: Pell grants, tax-free scholarships, tax-free employer educational assistance.
• If you used either the American Opportunity Tax Credit (AOTC) or Lifetime Learning Credit (LLC), deduct the costs claimed for tax credits.
• Complete a withdrawal request form with your 529 plan administrator, which may be on paper or online. To expedite the process, sending funds directly to the school is usually best, though in some circumstances you might send them to the student.
• If you anticipate having to make non-qualified 529 withdrawals, it can be useful to have the funds sent directly to the student, who’s taxed at a lower rate.
• Build in a little extra time for fund transfers, whether you transfer directly from the 529 to the college or choose to transfer directly to the parent or student. Be sure to withdraw funds in the same tax year that the qualifying expenses will occur.
• If there are multiple 529 plans to consider, strategize which education withdrawals to make, first. For example, a grandparent-owned 529 plan might be best to delay until spring of the beneficiary’s sophomore year. Otherwise, any withdrawals would count as income and potentially reduce financial aid.
• Accurately fill out Form 1099-Q when filing your income tax return, and save it for your 529 withdrawal records.

529 withdrawal penalties for non-qualified distributions

The last thing you want to do after years of saving to pay for college is facing a bunch of tax penalties. A 529 can be a huge asset for a family with a college student, but misusing account funds will negate some of its benefits.

Be aware of the basic 529 withdrawal penalties when you take money from a 529 for a non-qualified expense. And take the time to double-check on any gray areas or costs if you’re not sure whether it counts as qualified educational expenses.

The following are the general withdrawal penalties to keep in mind:

• Non-qualified 529 withdrawals will count toward your taxable income.
• Non-qualified 529 distributions incur an additional 10% federal income tax penalty on top of your regular tax rate.
• In addition to federal income tax penalties, you might be required to pay back state income tax deductions, if applicable.
• 529 withdrawal penalties only are assessed on non-qualified withdrawals of the earnings accrued on the account. All original 529 contributions are tax-free to withdraw.
• If you have a prepaid tuition plan, the beneficiary can only use those credits at a participating institution, and the account may pay much less for a non-participating institution.

FAQs

Make the most of your 529 plan

The 529 plan can help families with the immense task of saving for college for one or multiple kids. But be sure that you understand all of the rules around the withdrawal of 529 funds before you begin that process. You could save yourself a great deal of money by adhering to the guidelines set by the IRS and your specific 529 program.