When it comes to saving money for your child’s education – whether it be for a private elementary school or four-year college – many parents take the route of contributing to a 529 plan. These accounts earn interest, offer tax-free withdrawals and can even provide tax breaks in some states. Here are four mistakes that should be avoided when you’re using 529 plans.
- Taking Non-Qualified Withdrawals
Tax-free withdrawals are one of the main benefits of having a 529 plan. However, it’s only tax-free if the money you take out goes toward your beneficiary’s qualified higher education expenses (QHEE), which include:
- Textbooks and supplies
- Computers and internet access
- Special needs equipment
- Tuition and fees: This isn’t exclusive to just college. You can spend up to $10,000 annually for tuition and fees at an elementary or secondary public, private or religious school.
- Room and board: Your beneficiary must be enrolled at least half-time. If he or she lives off campus, the costs can’t be higher than the expenses to live on campus.
If you withdraw more than is required of the QHEE, that extra money is a non-qualified distribution and you have to pay a 10% tax penalty. Here are some of the non-qualified distributions:
- Student loans
- Sports and extracurricular activities
- Health insurance
There are a few exceptions to the 10% tax penalty. You won’t be penalized for making non-qualified distributions if your beneficiary:
- Receives a scholarship
- Dies or becomes disabled
- Attends a U.S. military academy
- Not Matching Up Withdrawals and Expenses in the Same Calendar Year
Withdrawals from a 529 plan are tax-free as long as an equal or greater amount of QHEE is paid during the same calendar year when you took out the money. If this isn’t the case, you may be penalized. Mismatches usually occur with spring semester tuition bills, which are usually sent out in December but paid for in January. To avoid any penalties, pay any tuition bills you receive as soon as they arrive.
- Not Clarifying the Best Method of Payment for the School
The best way to avoid the second mistake on this list is to request your 529 payment be made directly to the school. However, this could also work against you if you don’t know how the school views 529 plans. Some institutions treat direct 529 payments in the same manner as scholarships – a dollar-for-dollar reduction in financial aid. It’s best to check with the school first to clarify its policy on receiving funds directly from a 529 plan.
- Making Multiple Withdrawals for the Same Expenses
Your child might be lucky enough to have more than one 529 plan to draw from other than yours. It could be from grandparents, other relatives or friends. For this reason, it’s important to coordinate with the other account holders and decide who makes the withdrawal when it comes time to pay for your child’s school expenses. Multiple withdrawals for the same expense could lead to tax penalties.