While students and their parents may be all too aware of the challenges associated with saving for college, they should not overlook the fact that there are also some important rules involved in spending that money. Knowing how to withdraw money from your 529 account correctly can save you from incurring tax penalties or being caught short of funds at a critical time. While recent 529 plan rules now make it possible to withdraw funds for eligible high school and college expenses, this article refers primarily to college fund distributions. The same rules and advice apply to those using a 529 plan to pay for private high school expenses.
How to withdraw money from your 529 account
Money deposited in a 529 plan grows tax free, and can be withdrawn without taxes or penalties as long as it is put toward eligible education expenses. What is the penalty for withdrawing money from a 529 plan incorrectly? If you use the money for anything but IRS-approved education expenses, the portion of the funds attributable to investment gains is subject to ordinary income taxes plus a 10 percent penalty.
Here's what you can do to have 529 college fund money available when you need it and avoid taxes and penalties:
- Identify eligible expenditures
529 plan money can be used for a variety of educational expenses, including tuition, room and board, books and even computer equipment and services. Separate your eligible from non-eligible expenses, so you know how much 529 money can be applied to eligible expenses.
- Get the timing right
As soon as your child determines which school he/she will attend, find out precisely what the school's billing cycle is. This is important, because your 529 disbursements need to occur within the same calendar year in which the money was used for an eligible education expense. For example, at a college whose academic year consists of a fall and spring semester, if you make your payments for the upcoming semester in July and December, then you can take enough out of the 529 plan in that calendar year to cover both payments. Timing is related to when bills are issued and paid, and not associated with when the academic benefit is actually received.
- Understand the 529 plan's withdrawal procedures
Talk to the 529 plan sponsor about their procedures for authorizing disbursements. Depending upon the amount withdrawn, there may be extensive paperwork involved and some time allowance necessary for funds to be liquidated and transferred. In other words, be ready for what it takes to actually get the money from the plan to its destination so you don't get caught short when a bill is due or end up with a disbursement from the plan taking place in a different year than the payment of the expense.
529 plan withdrawal options
While adherence to the above steps should enable you to avoid IRS penalties, it's also important to avoid late payment fees from your students' private high school or college. Schools may also prevent your student from registering for classes if financial commitments are unresolved. Carefully review each school's preferences for receiving your payments, and/or place a call to the institution's financial services office to inquire about specific payment details. Your 529 plan high school or college fund withdrawal can be made payable to the school, the student, or to you.
- College fund disbursement payable to you
Does the school want you to include a coupon with your payment that helps them process it to your student's account? If so, most 529 college savings plans may be unable to accommodate that request. Instead, you may request that an amount to cover eligible education expenses be distributed to you (or your student), and you can combine that 529 plan check with the school's coupon to be mailed in one envelope. Because there will be two mailing delays, it is important to request distributions well in advance of the bill's due date.
- College savings plans' funds payable to student
With housing options limited at many colleges, it is often necessary or desirable for students to live off-campus during some of their school years. Can a 529 plan be used to pay rent? As long as your student is enrolled half-time or more, the IRS allows 529 college fund distributions for rent payments that are equal to or lower than the university's published room and board allowance. It may be convenient to withdraw 529 plan funds payable to your student so that he or she can pay rent while attending school.
- 529 plan payment payable to school
Many 529 plan sponsors have easy online check request portals. If your student's school is among those on the plan sponsor's list, and the school's name is listed exactly as required in the school's remittance instructions, you may be able to send a check directly to the college with a few simple clicks. Be sure to save a copy of the invoice being paid so you can prove that the distribution was made for eligible college expenses in the future.
If your student's school isn't available on the 529 plan sponsor's list, or if the school appears as "XYZ College," while the remittance instructions require checks payable to "The Trustees of XYZ College," choose to have the funds distributed to you (or your student), deposit the 529 plan check, and send your personal check payable per the school's instructions. Be sure to allow adequate time for this process.
Transitioning from saving for college to spending the college fund
Besides the mechanics of accessing the money for eligible education expenses, there are investment considerations as you prepare to transition from saving for college to spending the money:
- Shift from growth to more liquid securities
If you start saving several years before the 529 beneficiary starts college or private high school, you have time to invest in growth securities like stocks. These give you a greater opportunity for investment growth, which in turn makes maximum use of the tax benefit of a 529 plan. However, since growth investments may fluctuate wildly in value, as the time to use the money approaches you should downshift to more stable and liquid securities.
- Keep later-year savings outside the 529 plan
With a year or two to go before college, the time to benefit from the tax break on investment growth is greatly diminished. You may find it worthwhile to keep some of these later-year savings outside the 529 plan, so they can be more readily accessed and available for non-eligible expenses such as transportation, club fees, beer money, etc. Consider establishing certificates of deposit (CDs), or savings accounts specifically for handling the final years of education expenses.
What happens to a 529 plan if not used?
If it turns out that you have amassed more money in a 529 plan than the beneficiary needs to get through high school and college, first of all, congratulations! At a time when millions of students are struggling to get through school without taking on masses of debt, having a little surplus is not such a bad thing - especially since that surplus does not have to go wasted.
Here are some options if your child is approaching graduation without fully depleting the 529 plan:
- Graduate school
529 plan money can be used toward grad school at eligible institutions, which may prove very helpful if there are any funds left after earning an undergraduate degree.
- Computer equipment
529 money can now be used to pay for computer equipment, as long as it is bought while the beneficiary is attending a qualifying degree program and is used for educational purposes. Since this equipment can have a useful life long beyond college, it might be a good idea to buy some new equipment as the end of college approaches.
- Transfer to another family member
While 529 plans have a single beneficiary, these college savings plans can be transferred to a new beneficiary without penalty. If you have multiple children, one approach would be to load up on 529 funding for the eldest in particular (within tax limits), knowing that any excess can be handed down to the younger siblings - just like all those jeans and sweaters when they were younger.
Face it - education is expensive. If your problem is that you have too much money in a 529 plan, chances are you won't have to look too far to find a way to put that money to good use.