Cashing in Your 529 Plan to Send Your Kids to College

You’ve been saving money for college since junior was a baby, and now he’s going off to college. That’s wonderful, but before you withdraw funds from your 529 plan to pay college expenses, there are a few things you should know.

The 529 plan doesn’t rule out financial aid. Those funds are treated as the parent’s assets, and so will result in less of a reduction on eligibility for financial aid than if they were in the child’s name.

Only certain expenses may be paid from the 529 plan. For the 529 withdrawals to be tax free they must be used for qualified education expenses, such as tuition, fees, required books and supplies, and room and board. Flying your child from home to school and back again doesn’t count, nor does the fancy new laptop computer you buy him. (His Netflix subscription isn’t covered either.)

You may have to prove how you used the funds. Be sure to save billings from the school for the expenses as well as receipts for any other qualified education expenses that you pay, so you can prove what you used the funds for.

Additional withdrawals may be taxable. If you take out more than the amount of qualified expenses, then you’ll owe tax on the earnings withdrawn, and generally you’ll pay a 10% penalty as well. Penalties are waived if your student receives a scholarship and you have additional unused funds as a result of the scholarship.

It might be smart not to withdraw the full tax-free amount if possible. If you have income of $90,000 or less ($180,000 on a joint return), then you may qualify for the American Opportunity Tax Credit of up to $2,500 per year per student. This tax credit directly offsets income taxes shown on your tax return, and if it exceeds your taxes a portion may be refundable. If you claim a $2,500 American Opportunity Tax Credit on your federal tax return you must remove from Qualified Higher Education Expenses(QHEE) the $4,000 in tuition and related expenses that was used to support the credit.

Timing is everything. Be sure to withdraw funds from your 529 plan in the same calendar year that you pay college expenses. If you withdraw funds from your 529 plan and pay qualified education expenses the next year, or vice versa, you may end up paying tax even if the funds are used for educational expenses in a different year.