Financial Planning

Know the Rules to Avoid 529 Distribution Mistakes

As a continuation of one of our recent blog posts on 529 accounts, we now wanted to focus in on the various rules for distributions from those accounts. 529 plan account owners can withdraw any amount from their plans, at any time, but only the qualified distributions that we previously referenced (i.e., for college expenses, $10,000 per year for K-12 tuition/fees, etc.) will be tax-free.

For any non-qualified distributions, the earnings portion must be reported on the account owner’s or the beneficiary’s federal income tax return and is subject to income tax and could incur a 10% penalty. It is important to remember that the principal or your contributions to the 529 plan can always be withdrawn without penalty. However, in some states you may have to pay back any state income tax deductions you previously claimed if you later take a non-qualified withdrawal.

Additionally, the penalty on the earnings/growth portion of non-qualified withdrawals may be waived if there are extenuating circumstances, such as the following:

  • The student beneficiary receives a scholarship/tax-free educational assistance
  • Receipt of education tax credits, the American Opportunity Tax Credit (AOTC) or Lifetime Learning Tax Credit (LLTC)
  • Death or disability of the student beneficiary
  • The student beneficiary enrolls in a U.S. service academy
  • Return of excess distributions

You would still have to pay income taxes on gains in these circumstances unless you pay for a qualified expense but would avoid the 10% penalty. It is important to keep in mind that any qualified expense that is used to justify an education tax credit (AOTC or LLTC) cannot also be allocated as part of qualified distribution from a 529 plan.

If the student beneficiary gets a scholarship or another exemption occurs, one strategy to avoid taxes and penalties is to change the beneficiary of the 529 plan (or a portion) to a sibling that will have qualified expenses.

Ready to Withdraw?

Thankfully, the rules for how 529 distributions can be executed are pretty flexible for most plans, allowing owners to pay costs directly from the plan assets or reimbursing themselves after paying expenses from personal funds. For the latter, you must submit your request for the cash reimbursement from the plan within the same calendar year—not the same academic year—as you make the payment. If you have a credit card that earns points or cash back, we recommend using that for qualified expenses to get the points/cash back and then reimbursing from the 529 plan.

As with most things in life, making a plan and keeping good records usually leads to a better outcome. Please contact us if you would like to start a new education planning discussion or review any existing plans.

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