Important Things to Know about 529 College Savings Account Withdrawals
Understanding the Tax Implications and Rules for 529 Plan Withdrawals
Section 529 college savings plans are a popular way to save for educational expenses, offering significant tax advantages. Qualified withdrawals from these plans are typically exempt from federal income tax and often state income tax as well. However, not all withdrawals are tax-free, and there are important considerations and limitations to be aware of when accessing these funds.
Understanding Taxable Withdrawals
Withdrawals from a 529 plan may be taxable if they exceed the account beneficiary’s adjusted qualified education expenses (AQEEs) for the year. AQEEs include tuition and fees, room and board for students enrolled at least half-time, required books, supplies, equipment, computer hardware, peripherals, software, and internet access, as well as special needs services. Any federal income tax-free educational assistance, such as Pell grants, scholarships, fellowships, tuition discounts, veterans’ educational assistance, and employer-provided educational assistance, must be subtracted from these expenses. Costs used to claim the American Opportunity Credit or Lifetime Learning Credit also reduce AQEEs.
If total withdrawals for the year exceed AQEEs, the excess withdrawn earnings are taxable. When withdrawals are within AQEEs, the withdrawn earnings remain federal income tax-free. For example, if a student incurs $50,000 in college expenses but receives $35,000 in tax-free scholarships, the AQEEs would be $15,000. If you took $50,000 out of a 529 plan to pay for these expenses with $10,000 of this representing earnings, there would be $7,000 treated as taxable (70% of the earnings), since only 30% or $15,000 remains as AQEEs.
Understanding the tax implications of 529 plan withdrawals is crucial to maximizing your savings for education expenses.
Changing the Beneficiary and Non-Educational Withdrawals
Account owners can also change the beneficiary of a 529 plan to themselves and use the funds for their own AQEEs if they decide to go back to school. However, withdrawals for non-educational purposes will result in taxable earnings and may incur a 10% penalty tax.
The 10% penalty on taxable withdrawals does not apply if the earnings are taxable only because AQEEs were reduced by tax-free educational assistance or costs used to claim education credits. Additionally, the penalty is waived if the account beneficiary dies, becomes disabled, or attends a U.S. military academy.
Expanded Uses for 529 Plan Withdrawals
Federal income tax-free withdrawals from a 529 plan are also allowed for K-12 tuition (up to $10,000 per year), registered apprenticeship programs, and student loans (up to $10,000 per beneficiary and per sibling). However, some state plans may not offer state income tax benefits for these withdrawals.
If there are leftover funds in a 529 plan, starting January 1, 2024, up to $35,000 can be rolled over to a Roth IRA for the beneficiary without tax or penalty, provided the account has been open for more than 15 years. Various rules apply, so consulting a tax advisor is recommended.
Managing 529 Plan Withdrawals
Understanding the rules for 529 plan withdrawals is crucial to maximizing their benefits and avoiding unexpected taxes. Contact your tax advisor to ensure compliance and optimize the use of your 529 plan funds. Each withdrawal is reported to the IRS on Form 1099-Q, detailing the total amount withdrawn, the earnings, and the basis from contributions. Properly managing these withdrawals can help you make the most of your educational savings.
Questions?
Adam manages a variety of tax and accounting engagements for business clients in numerous industries, including manufacturing, real estate, construction, alternative investments, and professional services. He has experience in federal tax, multi-state corporate income and franchise tax, and municipal income tax. In addition to his tax compliance background, Adam specializes in preparing and managing complex partnership engagements.