Celebrating and Decumulating an Education Savings Plan
May is full of reasons to celebrate and appreciate, from Star Wars Day on May the 4th (…be with you) to Mother’s Day mid-month to remembering our nation’s fallen soldiers on Memorial Day at month-end. Add to this list May 29th (5/29) which holds its significance by recognizing National 529 Day to help states promote the benefits and participation in 529 education savings plans (legally known as a “qualified tuition plan”).
Brief History of 529 Plans
529 plans are nearing thirty years of existence. The first prepaid college savings vehicle was created in 1986 by the state of Michigan, followed by a key US. Court of Appeals victory in 1994 exempting income from the plan from federal taxation. On the heels of this victory came Section 529 of the Internal Revenue Code (and thus the plan nickname) in 1996 which established federal rules for the plans, and then legislation in 2001 (Economic Growth and Tax Relief Reconciliation Act of 2001) making distributions tax-exempt.1
It is this history of the plans, as state creations and not federal creations, that is the genesis for differences in plans across the nation. Currently, the District of Columbia along with forty-nine states (Wyoming is the exception) offer a 529 plan, and while all offer the same federal tax benefits the specific state tax benefits and structure of the plan often vary by state.
While these college savings accounts had their start at the state level, the popularity of 529 plans ballooned since that 2001 federal legislation with total assets within all U.S. 529 plans exceeding $400 billion at year-end 2022.
Benefits of 529 Plans
Indeed, it seems the benefits of using 529 plans for college education savings are well known, and recent tax legislation passed in 2017 and 2019 expanded potential uses to cover K-12 education expenses and a portion of a beneficiary’s student loan debt.
Benefits of a 529 plan2 include, but are not limited to:
- Tax-deferred compounding of contributions and earnings. A 529 plan operates similarly to a Roth IRA, where dollars are taxed before contribution to the plan and then grow tax-free while inside the plan.
- Tax-free withdrawals for qualified education expenses such as tuition, fees, room and board, books, and supplies.
- Tax-deductible contributions (in some states).
- The account owner retains full control over assets with the ability to change beneficiaries or transfer unused assets to certain other family members.
- Covers any qualified expense at accredited schools throughout the U.S. and overseas, including vocational/trade schools as well as apprenticeship programs.
- No income limits on contributors.
- No age limits on beneficiaries or contributors.
- Starting in 2024, 529 plan dollars can be transferred to a Roth IRA. For additional details, and the myriad of restrictions, click HERE.
529 Plan Withdrawals: A Case Study on “Decumulation”
With the benefits of accumulating dollars in 529 plans well established, eventually, savers are faced with the less discussed flip side of “decumulating” by withdrawing dollars from a plan to use for a beneficiary’s education expenses. What may seem like a simple task has several key guidelines to keep in mind to avoid running afoul of IRS guidelines or unknowingly violating income tax rules.
Consider this case study with common misconceptions and mistakes for 529 plan withdrawals (along with tips to avoid them):
John is the owner of a 529 plan for his daughter, Ava, the beneficiary, which now has a balance of $50,000. Ava began college in the fall of 2022 and incurred a $10,000 tuition bill from the university, paid $1,000 for books/supplies, and $4,000 for room and board (a total of $15,000 in qualified education expenses).
John paid these costs from his checking account and in early December requested a 529 plan distribution check made payable to him for reimbursement of these $15,000 in expenses. In addition, John knew he would need to pay Ava’s spring 2023 tuition bill ($10,000), so in late December 2022 he requested another $10,000 distribution from the 529 plan (a check made payable to him) and he used those dollars to pay Ava’s spring tuition in early January 2023.
It is now early 2023 and John and his wife Jane are preparing to file a joint tax return on which they will report Adjusted Gross Income of $150,000. Ava was mailed a Form 1098-T from her university stating a $10,000 tuition expense. John received a Form 1099-Q from the 529 plan provider for $25,000. That 1099-Q has a box checked in Section 6 next to the statement “Check if the recipient is not the designated beneficiary.”
MISCONCEPTION: John was required to show proof of the education expenses before receiving the 529 plan distribution checks.
Fact: The 529 plan provider (i.e. the institution that administers the plan) is not in the expense-policing business. It is John’s responsibility as the owner to communicate to the plan provider at the time of a distribution request whether a withdrawal is for a QHEE (Qualified Higher Education Expense) or not. The ultimate overseer is the IRS, and if John were audited, he must provide documentation of the college education expenses paid.
Tip: Use a file folder to keep all education bills, invoices, and receipts. Using a folder for different calendar years is ideal, and within the folder simply attach the education bill to either a copy of the check that paid it (or note the 529 plan confirmation number provided at the time of distribution). Aim to over-document expenses.
MISTAKE: When John chose to have the 529 plan issue a check made payable to him it inadvertently opened the door for complications. The core problem: there is a mismatch between the individual that incurred education expenses (Ava) and the individual that received the 529 plan distribution (John).
Fact: As background, here is a quick overview of the two tax forms3 John and Ava received:
- 1098-T: this statement from a college/university sent to the student shows tuition paid net of scholarships (along with verification of the student’s eligibility for certain education tax credits). One confusing aspect of this form is it ONLY shows tuition, not other qualified education expenses such as textbooks and supplies, so it is not a comprehensive statement of a student’s Qualified Higher Education Expenses.
- 1099-Q: this statement from the 529 plan provider shows the distributions from a 529 plan during the calendar year made to an individual. If the distributions were all used for Qualified Higher Education Expenses, as is often the case, then nothing on this form needs to be reported on a tax return.
In John’s case, the IRS sees the box in Section 6 checked4 and interprets it correctly as a 529 plan distribution has been made to someone other than the beneficiary. The IRS (blind to the “reimbursement” nature of the transaction) takes a position that the 529 plan distribution check John received is a non-qualified expense and subject to tax. The IRS flags John’s and Jane’s tax return to audit and impose this tax (and a 10% penalty), resulting in John having to respond to the IRS with an explanation in hopes of bringing clarity to what has transpired (and to have the taxes and penalty waived).
Tip: How could John avoid this situation? The answer is quite simple, and the key is to whom 529 plan dollars should be distributed. When requesting a 529 plan distribution, ask the plan provider to send the dollars to one of two places:
- directly to the university/college, or
2. to the beneficiary of the 529 plan (NOT the owner).
In this case, had the 529 plan distribution check been made payable to Ava then the 1099-Q tax form would have used her information and Section 6 would have remained unchecked.
One way to facilitate a reimbursement like John’s situation is to open a checking account at a bank with the account owner and beneficiary as joint owners. In our example, had the 529 plan distribution check been made to Ava then that check could be deposited to John’s and Ava’s joint checking account and then from there transferred to John for reimbursement of his $15,000 paid out of pocket.
MISCONCEPTION: John believed the timing of the 529 plan distributions was irrelevant when compared to when the education expenses were paid.
Fact: When John made a December distribution from the 529 plan for spring tuition that would be paid in January of the following calendar year he opened the door for another mismatch in reporting. In this case, he withdrew $25,000 from the 529 plan during the calendar year 2022 but only $15,000 in education expenses were paid in 2022.
Tip: Even if 529 plan distributions are made to the correct person/entity (the 529 plan beneficiary or directly to the university), ensuring expenses and 529 plan distributions occur during the same calendar year will avoid a perceived “excess” 529 plan distribution being seen as a non-qualified distribution by the IRS.
MISTAKE: John did not consider federal income tax credits before making the 529 plan distributions. His and Jane’s income falls below the income limitations for federal tax credits, but having paid for 100% of Ava’s education costs with 529 plan dollars he cannot claim an education tax credit for the 2022 tax year.
Fact: there are two federal tax education credits available (see brief overview below), and taxpayers should consider (a) if they will be eligible for one or both credits based on their income level; and (b) how to coordinate these credits with 529 plan withdrawals.
- American Opportunity Credit (AOTC)5: for qualified education expenses paid for the first four years of higher education. The maximum annual credit is $2,500 per eligible student. Importantly, to claim the full credit a married filing jointly taxpayer must have modified adjusted gross income (MAGI) of $160,000 or less ($80,000 or less for single tax filers). Note this income limit is not indexed/increased annually and has remained the same since its inception for the 2009 tax year.
- Lifetime Learning Credit (LLC)6: for undergraduate, graduate, and professional degree courses, this credit is worth up to $2,000 per tax return. There is no limit on the number of years the credit can be claimed, and the income limit is the same as the AOTC limits outlined immediately above.
Tip: You cannot “double-dip” by paying for an education expense with 529 plan dollars and also using those same education expenses to claim either the AOTC or LLC credit. Because of this, consider first if your income allows you to claim a tax credit, and if so, consider paying enough education expenses out of pocket to fully maximize the appropriate tax credit.
In closing, as we celebrate the benefits of 529 plans on National 529 Plan Day we should also acknowledge the possible pitfalls in the decumulation phase. If you are in the midst of this 529 plan withdrawal phase or will be soon, reach out to your Bridgeworth advisor with questions or to Bridgeworth’s Director of Planning (Jonathan Millican) to explore ways Bridgeworth may be able to help you.
Footnotes:
2 https://www.irs.gov/taxtopics/tc313
3 https://howtopayforcollege.com/blog/what-do-you-do-with-form-1098-t-and-1099-q
4 https://www.irs.gov/pub/irs-pdf/f1099q.pdf
6 https://www.irs.gov/credits-deductions/individuals/llc
Other helpful resources:
https://www.savingforcollege.com/article/how-to-withdraw-money-from-your-529-plan
https://www.bankrate.com/loans/student-loans/does-your-state-offer-529-plan-tax-deduction/
https://www.irs.gov/pub/irs-pdf/f8863.pdf
https://www.irs.gov/pub/irs-prior/i8863–2009.pdf
Bridgeworth Wealth Management is a Registered Investment Adviser.
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