By Brennan Hannon, Business Development Manager, CollegeInvest
July 20, 2021
It is almost autumn, and that means families across the country are getting ready to make withdrawals from their 529 plans. Here is what to consider when taking withdrawals.
Use funds only for qualified expenses
529 plans are tax-advantaged vehicles and to qualify for the tax advantage, withdrawals must be taken for qualified expenses. A qualified expense is called a qualified higher education expense and might be written as QHEE in some publications. Here is a list of expenses that qualify as QHEE:
- Room and board (on and off campus) is eligible. Each institution publishes their cost for room and board, so if your student is living or dining off campus, be sure to keep expenses within the amounts that institution published. Any room and board expenses above the published amount for that school would be paid out of non-529 funds.
- Fees charged by the school required for attendance, such as technology and lab fees. Some fees are not qualified, such as fraternity dues.
- Books and supplies
- Internet access
- Software required for attendance
- Special needs equipment
What is not qualified?
- Transportation (travel to and from school), campus parking and other transportation is not qualified.
- Extracurricular fees or club membership dues
- Furnishing a dorm room
Coordinate Your Withdrawals
Coordinate your withdrawals with other tax benefits.
American Opportunity Tax Credit (AOTC)
This credit gives a family a $2,500 tax credit – 100% for the first $2,000 and 25% for the next $2,000. This $4,000 shall be paid from somewhere other than a 529 to be eligible for the tax credit. Can be taken a total of four years. Income limits apply.
Lifetime Learning Credit (LLC)
If you have already exhausted the AOTC, you can take the LLC instead. This gives a 20% credit for the first $10,000 in expenses. This $10,000 shall be paid from somewhere other than a 529 to be eligible for the tax credit. Income limits apply.
529 plan withdrawals must be made the same calendar year the payment is made, so anytime you reimburse yourself for expenses do it in the same calendar year. For example: When you pay tuition in December, it usually covers classes from January-May of the following year, but since you paid the bill in December, your withdrawal must come before the calendar year ends.
Perhaps your student has received a scholarship. If so, congratulations! If you want to take advantage of the penalty-free withdrawal option you must withdrawal up to the total scholarship amount, in the same calendar year as the value of the scholarship. For example: if a scholarship pays for $4,000 for fall semester, you can withdraw up to $4,000 before Dec. 31 of that year to avoid a penalty.
Important: If this money is distributed to the student, it could affect that student’s financial aid application. Consult with your financial aid counselor to determine the best option for your family.
Third-party withdrawals and financial aid
Distributions from a third party, such as a grandparent, count as unearned income to the student, potentially having an adverse effect on financial aid outcomes. Unearned income to a student reduces financial aid by 50% of that amount. Timing third party withdrawals to happen AFTER the student has completed their last FAFSA application will avoid any impact on financial aid. Another option is to transfer money to a parent-owned account (be sure to consult with your tax professional to avoid a tax consequence).
NOTE: This will change starting for the 2023 FAFSA application year (2024-25 school year). Third-party distributions will no longer be counted on the financial aid application.
The 529 account owner is responsible for keeping records for tax purposes. Keep copies of all statements and bills should they ever be needed.
If you are considering making a non-qualified withdrawal, consider the rules. Growth on non-qualified withdrawals is taxed at state and federal level, your state may claw back any tax deduction you took on the principal portion, and the IRS will add a 10% penalty on the growth portion.
K-12 tuition, student loan payback, and apprenticeship withdrawals
The federal government now allows withdrawals for these reasons without tax or penalty. Each state treats these withdrawals differently, so check with your own state’s tax laws to see if there is a consequence for these withdrawals.
About the Author
Brennan Hannon is a Business Development Manager with CollegeInvest, the State of Colorado’s 529 program. In his current role, Brennan partners with the financial community to expand business through college planning and helps families create an educational legacy for their children and grandchildren. Brennan received his bachelor’s degree in Organizational Leadership & Management from Concordia University in St. Paul, Minnesota. He lives in Denver with his family and spends most of his free time enjoying Colorado’s outdoor playground.