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Marc A. Hebert's Money Sense: Staying in bounds with Section 529 Plan withdrawals

October 13. 2018 6:57PM

Perhaps you have a son or daughter going off to college and have begun paying the costs. Hopefully you have been saving for a long time for this moment and are just deciding the best way to pay. One of the ways to save that you may have used is a Section 529 plan.

If so, there are some rules for withdrawals from these plans that you should know. Since the funds inside the plan were accumulated tax-free, distributions from the plan are also tax-free if they are used for qualified expenses. This means that they are completely free from federal income tax and may also be exempt from state income tax.

Qualified expenses include tuition, fees, required books and supplies, and room and board (assuming the student is attending at least half-time).

Computers and related equipment and the additional expenses of a "special needs" beneficiary are also considered qualified. Eligible institutions include any college or graduate school in the United States or abroad that is accredited by the Department of Education. Furthermore, as part of the Tax Cuts and Jobs Act, up to $10,000 per year can be used for K-12 tuition expenses.

Some expenses that one might think are qualified actually aren't. Here is a list of some of those expenses:

. Fees for athletics, sports clubs, or school-sponsored groups

. Transportation costs to and from school

. Repayment of student loans

. Health insurance

Room and board is a category that needs more explanation. The costs in excess of the amount the school includes in its "cost of attendance" figure for federal aid purposes are not qualified. If the student is living off campus, the school's cost of attendance becomes the maximum amount eligible to be withdrawn tax-free for rent and groceries.

If you are uncertain of the treatment of an expense, check with your plan administrator.

Watch the rules carefully. A nonqualified withdrawal is any withdrawal not used to pay the qualified education expenses detailed above. For example, if you take money from the account to pay for medical bills, you are making a nonqualified withdrawal.

The earnings portion of any nonqualified withdrawal is subject to federal income tax and a 10% federal penalty. There may be a state penalty and income tax, as well. The principal portion of your 529 plan withdrawal is not subject to federal tax or penalty.

To maximize the use of 529 plan funds, it is important to coordinate your withdrawals with the education tax credits (American Opportunity credit and Lifetime Learning credit). The reason why is because the tuition expenses used to qualify for a credit can't be the same tuition expenses paid for with tax-free 529 funds. This would be, in effect, double-dipping.

Also, remember that if you accidentally take too much money out, you can still put the excess back into a different 529 plan so that the amount is no longer treated as a distribution. There is a 60-day rollover window to do so - just make sure you have not rolled over that child's 529 plan account within the prior 12 months. If you have done so, this technique will not work. If you are outside the 60-day window but within the same calendar year, you may be able to prepay next semester's expenses.

While the IRS's publications and tax forms don't state that the withdrawals taken from a 529 account must match the payment of qualifying expenses within the same tax year, it is best if the expenses match up. The IRS has indicated it will make proposals to adopt this rule.

Considering the complicated nature of 529 plan rules, we suggest you check with your personal tax preparer before making your 529 plan withdrawals.

Marc A. Hebert, MS, CFP, is a senior member and president of the wealth management and financial planning firm The Harbor Group of Bedford. Email questions to Marc at Your question and his response might appear in a future column.

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