After years of stashing money away in a 529 account, inevitably the day will arrive to start withdrawing the cash.
While that might seem like a simple enough act, it can be a bit tricky to shelter the withdrawals from penalties and taxes while capturing a valuable federal tax credit.
Here are the steps that account owners need to take:
1. Calculate expenses
First, your clients need to calculate what their qualified 529 expenses are. This is an important step because only 529 distributions used for qualified expenses will be free from the potential 10% penalty and federal income taxes and, if applicable, state taxes.
Here are qualified college expenses:
- Tuition and fees.
- Room and board. If a student is living off campus, the amount deducted can’t exceed the room/board amount contained in the college’s official cost of attendance.
- Books and supplies.
- Computers and related equipment.
- Special needs equipment. This refers to equipment that disabled and special needs students need for attending college.
- Student loans. Repayment of student loans with 529 money imposes a lifetime cap of $10,000.
Beyond college, another qualified 529 expense is up to a $10,000 a year payment for tuition and fees at K-12 private schools.
Here are some of the college expenses that are not qualified 529 expenses:
- College applications and standardized testing.
- Health insurance, which includes health insurance offered by the college.
- You can’t deduct any travel costs to or from a campus or while there.
- Sports expenses.
2. Avoid double-dipping
What your clients need to understand when tapping into 529 accounts is that you can’t count the expenses toward a qualified 529 distribution that they also use to qualify for a federal educational tax credit. These credits are the American Opportunity Tax Credit (AOTC) and the Lifetime Learning Credit (LLC).
This prohibition makes sense since the government doesn’t want taxpayers to use the same money to capture two tax benefits. In other words, you can’t enjoy a 529 tax-free withdrawal and use the same money to qualify for the AOTC or the LLC. You will need to spend non-529 money to capture a federal education tax credit and so clients will need to plan their 529 withdrawals accordingly.
Here is what you need to know about the two tax credits when planning 529 withdrawals:
With the AOTC, which is the most valuable credit, parents can claim a maximum $2,500 tax credit annually for each child in college. Taxpayers will capture 100% of the first $2,000 they spend on qualified college expenses for a student and 25% for the next $2,000 spent. Consequently, parents would need to use $4,000 in eligible expenses outside of a 529 account to capture the full AOTC. So, when parents claim the AOTC or the LLC, they need to make sure they aren’t using the same expenses twice.
The Lifetime Learning Credit provides up to a $2,000 tax credit on the first $10,000 of college expenses.
Here are two examples of how 529 withdrawals and tax credits work:
Example No. 1: Parents withdraw $4,000 from a 529 to pay for college tuition. They spend a total of $7,000 to cover the child’s qualifying expenses at a local state university. They wouldn’t be able to claim the full AOTC because $4,000 in expenses were covered by 529 withdrawals. After subtracting the $4,000, there is only $3,000 left, paid with non-529 money, to claim the AOTC. In this case, your clients would only capture a partial tax credit. Since the tax credit is so valuable, the parents should have considered using only $3,000 from a 529 account so they could enjoy the full AOTC.
Example No. 2: Parents withdraw $50,000 from a 529 plan to pay for college expenses and they spent another $4,000 from a savings account to pay for eligible expenses at a private college. Since the client spent $4,000 with non-529 money they could capture the full AOTC.
Income limits for federal education tax credits
To claim the full AOTC or LLC, your client’s modified adjusted gross income (MAGI) must be $80,000 or less ($160,000 or less for married filing jointly). You receive a reduced amount of the credit if your MAGI is over $80,000 but less than $90,000 (over $160,000 but less than $180,000 for married filing jointly).
To claim a federal education credit, your clients must first receive IRS Form 1098-T from the college. It should arrive by the end of January each year. This form will include the tuition, but not room and board.
Bottom line: Parents will need to determine how much they want to withdraw from a 529 versus other cash sources to make sure they can capture the full federal educational tax credit. This assumes, of course, that they qualify for a tax credit.
3. Keep good records
The 529 provider will provide statements that include contributions, earnings and withdrawals, but it is up to your client to keep receipts of the qualified 529 expenses.
4. Withdraw funds in the right year
It’s important that withdrawals your clients take from their 529 savings accounts match the payment of qualifying college expenses in the same tax year.
In addition to receiving the 1098-T, taxpayers will also receive IRS Form 1099-Q from their 529 plan that lists 529 distributions for the tax year. The withdrawn amount used to pay tuition should match the tuition documented on Form 1098-T. (Form 1098-T does not include room/board expenses or other expenses beyond tuition/fees.)