Establishing a 529 college savings plan is simple. But taking money out can sometimes be dicey, so it’s important to understand the rules.
The reason so many families pay for college through a 529 account is its celebrated tax benefits, including the ability to shield the account from taxes for potentially many years. But plenty of unlucky parents have discovered that the tax reprieve isn't always airtight.
Troubles can surface when you start draining a 529 account. If you don't understand the tricky withdrawal rules, you may ultimately face a nasty tax bill. The process, acknowledges Mark Kantrowitz, the founder of FinAid, a college financial aid Web site, is "complicated" and "can give people pause."
Pulling money out of a 529 account seems simple enough. Use a 529 to pay for qualified college expenses and all your withdrawals are tax free. But here's a catch: Your withdrawals can't exceed your college expenses for the year. So if you spend $10,000 on legitimate costs and you withdraw $12,000, some of that $2,000 will be subject to taxes, as well as a 10 percent penalty.
Families get entangled in the excess withdrawal rule in a couple of ways. Some parents inadvertently pull out too much money when they prepare to pay for January's tuition, says Kalman A. Chany, president of Campus Consultants Inc. in New York City and the author of Paying for College Without Going Broke. They withdraw 529 money in late December for an expense that won't occur until the following calendar year.
The other pitfall is mixing 529 withdrawals with the federal Lifetime Learning or Hope Scholarship tax credits, but both are valuable tax credits because they reduce a tax bill dollar for dollar. (Tax credits are far more valuable than tax deductions.)
The maximum Hope tax credit for 2008, for instance, was $1,800 per eligible student, with the requirement that a family spend at least $2,400 in tuition and fees for freshmen and sophomores. The Lifetime Learning tax credit awards a family a maximum tax credit of $2,000, or 20 percent of $10,000 paid for tuition and fees. Income limits exist; for example, both the Hope and Lifetime tax credits begin to phase out at $48,000 of adjusted gross income for single filers and $96,000 for joint filers in 2008.
The trouble occurs when families claim one of these tax credits for the same expenses that they've covered with their 529 proceeds. The government forbids parents to double dip college tax benefits.
"If you claim a tax credit, then the tuition you use to claim the credit can't be used against a 529 distribution," says accountant Joe Hurley, founder of Savingforcollege.com, a comprehensive 529 planning resource.
Suppose, for instance, that you claimed the Lifetime Learning tax credit by spending $10,000 on tuition for your child, and that the $10,000 came from your 529 account. This is a big no-no.
What can you do to avoid triggering taxes? "Most people are going to have to consult an expert," Hurley advises. You can also obtain the rules from IRS publication 970, Tax Benefits for Education, on how to sidestep these problems.
Lynn O’Shaughnessy is a financial journalist based in California.