A Section 529 plan is a savings vehicle that allows parents and other family members to save money for the college education of a child, grandchild, niece or nephew, or even themselves, on a tax-advantaged basis. Contributions to Section 529 plans are tax-deferred, earnings likewise grow tax deferred as long as they are left within the account. If you use the money for qualified higher education expenses, the distribution is generally tax free. You have three options when taking the distribution: Have the investment company send the money directly to you, have the money sent direcly to the beneficiary or have the money sent to the college or university. Each course of action has advantages and disadvantages.
Contact the investment company that holds your 529 plan or plans. Ask them to send you a check for whatever amount you need. The investment company will send you a check or wire the money into the account according to your instructions. They will also send you a Form 1099-Q, which they will also send to the IRS, notifying them that you had income from them during the year. Since the distribution is not taxable, you will not exclude the income on your tax return. However, the IRS may notice the missing income, and challenge you. You must be able to demonstrate that you used the income for a qualified educational expense. To avoid this hassle, Joe Hurley, a certified public accountant and expert on Section 529 plans, recommends you go to Step 2.
Direct the investment company to send the money to the beneficiary. In this case, the Form 1099-Q will have the beneficiary's Social Security number on it. You are left out of the tax equation. As long as the student has educational expenses that exceed the dollar amount of the distribution, there will be no tax on the distribution. The student will have nothing on her tax return, and Hurley says audits are rare, but are easily dealt with when they do occur, as the beneficiary will have ready access to college and billing records.
Request the distribution go directly to the school. This also keeps your personal tax return out of the picture. However, Hurley warns that some schools may penalize the student's need-based financial aid if they receive support from a Section 529 Plan.
Tips & Warnings
- If your beneficiary is also claiming other educational related tax credits, there may be a tax consequence to your Section 529 plan distribution. Specifically, your beneficiary must reduce qualified educational expenses by the amount of any tax-free educational assistance, to avoid running afoul of anti-double-dipping rules. You cannot use federal tax credits, such as the Hope and Lifetime Learning Credit for the same expenses your 529 plan is paying for. See IRS Publication 970, Chapter 9, for more details.
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