Q: My husband and I have been pretty good about contributing to our daughter’s 529 plan over the years. She just started her first year at the university and the expenses are piling up. How do we get reimbursed from her 529 plan? Are there limits to how much we can withdraw?
A: As the 529 account owner, you can instruct the plan provider to send you a check to reimburse you for your payment of your daughter’s college expenses. However, calculating the amount you can withdraw tax-free can be kind of tricky. Here are some key points to remember.
Withdrawals from 529 plans are tax-free only if they pay for the qualified educational expenses of the beneficiary. Qualified educational expenses include tuition, books, living expenses, technology, adaptive equipment for any special needs, and other bona fide costs of attending an eligible post-secondary educational institution. In addition, up to $10,000 per year can be used for kindergarten through 12th grade education. If you make a withdrawal for unqualified expenses, you will pay a 10 percent penalty on your gains plus taxes on those gains.
The amount you can withdraw tax- and penalty-free is net of any other tax-free educational assistance your daughter receives. Did your daughter get any tax-free scholarships this year? If so, you will need to reduce your withdrawal by that amount. Did she receive any educational assistance through a qualifying employer program? If so, you will need to reduce your withdrawal by that amount also. The same goes for any veteran’s educational assistance payments she receives and any expenses used by you to justify the American Opportunity Tax Credit (AOTC) or the Lifetime Learning Tax Credit (LLTC). In other words, the IRS doesn’t want you double dipping on tax credits to pay for your daughter’s education.
An example will illustrate how this works. Let’s suppose your daughter’s college expenses for the calendar year total $30,000. Suppose further that she has a tax-free scholarship worth $500 per semester and that you claim the maximum $2,500 of AOTC. To calculate the maximum withdrawal, you can take from your 529 plan without tax or penalty, you would reduce the $30,000 in expenses by the $1,000 (for two semesters) in tax-free scholarships she received. You would also reduce it by the $4,000 in expenses used to generate the $2,500 in AOTC. (You may want to talk with your financial advisor if you don’t recall how the AOTC works.) This leaves you with eligible expenses of $25,000 for the year. If you withdraw more than $25,000, the excess will be considered non-qualified and you will owe a 10 percent penalty and tax on part of the excess. Just to confuse matters, some excess withdrawals are exempt from the 10 percent penalty, though they are all subject to taxation. Your financial advisor can help you figure out the arcane details.
As you take withdrawals from your 529 plan, a couple of IRS forms will be important to you. Every year, your daughter’s university will send you a copy of IRS Form 1098-T showing the amount of tuition and fees required for enrollment. This, along with receipts for other qualified expenses, will be the basis for calculating how much you can withdraw from your 529 without taxes or penalties.
In addition, your 529 provider will send you a 1099-Q for the year the withdrawals are made. The form contains three important pieces of information. Box 1 contains your total distributions for the year. Box 2 contains the amount of the distribution that comes from income or earnings on your invested amount. Box 3 contains the amount of your distribution that represents your cost basis. The information on your 1099-Q will help your tax professional calculate how much tax you owe on your 529 withdrawals.
One note of caution: do not confuse academic years and calendar years. Although the IRS rules do not explicitly state this, most 529 professionals agree that distributions from 529 plans should be taken in the same calendar year in which the qualified expenses were paid. For example, if you pay tuition in December 2022 for the semester starting in January 2023, you need to take your 529 withdrawal in 2022.
Steven C. Merrell MBA, CFP®, AIF® is a Partner at Monterey Private Wealth, Inc., an independent wealth management firm in Monterey. He welcomes questions you may have concerning investments, taxes, retirement, or estate planning. Send your questions to: Steve Merrell, 2340 Garden Road Suite 202, Monterey, CA 93940 or email them to smerrell@montereypw.com.