6 tips to ensure your 529 withdrawals make the grade with the IRS

This article was fact-checked by our editors and Jennifer Samuel, senior product specialist for Credit Karma.

Putting money into a 529 college savings plan is easy — a few mouse clicks and it’s done.

But what about taking the money out when you need it to pay college costs? That’s when things can get complicated. So you’ll want to be sure you know how to make 529 withdrawals correctly.

Otherwise, you could end up owing taxes and penalties on withdrawals. Here are six things you should know about making 529 plan withdrawals.

1. Know what counts as qualified expenses
2. Learn when you might have to pay tax
3. Dropping a class doesn’t mean disaster
4. Know how to report 529 withdrawals
5. Learn how 529s work with education credits
6. Know what to do if you don’t need all the money in your 529

1. Know what counts as qualified expenses

The benefit of a 529 plan account is that qualified withdrawals are federal income tax-free — as long as the total withdrawals for the year don’t exceed your adjusted qualified higher education expenses. You can also use 529 plan funds tax-free for up to $10,000 of tuition costs per student at a public, private or religious elementary or secondary school.

Before Jan. 1, 2018, an eligible educational institution typically meant a college or university. But the Tax Cuts and Jobs Act expanded the use of 529 plan funds to include up to $10,000 of tuition per year, per child for enrollment in kindergarten through 12th grade.

So what counts as a qualified expense?

According to IRS rules, these are “expenses required for the enrollment or attendance of the designated beneficiary at an eligible educational institution.” This generally includes tuition and fees, books, supplies and equipment, computer equipment, software, internet access, and room and board for a student who is enrolled at least half time.

2. Learn when you might have to pay tax

Generally, 529 withdrawals aren’t taxable if you use the money for qualified education expenses, but there are situations in which they could be.

You withdraw more than you need

You need money to pay for college expenses and you can get that money from multiple sources. Some of them, such as scholarships, might be tax-free.

When you withdraw money from your 529 plan, you should only take as much as you need to cover qualified costs that you couldn’t pay from other tax-free sources. For example:

• If you have $8,500 in qualified education expenses for the year …
• And you receive a tax-free scholarship of $3,000 …
• Then you subtract that tax-free scholarship amount from your total qualified education expenses to determine your adjusted qualified education expenses: $8,500 – $3,000 = $5,500.

In this scenario, if you withdraw more than $5,500 from your 529 college savings plan for the year, you could have to pay federal income tax and a 10% penalty on the portion of that withdrawal that came from your plan’s earnings.

The financial institution that manages your plan should send you a Form 1099-Q each year that you make a withdrawal, showing how much you took out and the portion of the distribution that comes from earnings. Note that it’s possible not all the earnings reported on the 1099-Q will be taxable.

You withdraw before you need the money

Taxable and tax-free distributions are determined on an annual basis, so you want to withdraw only the amount you’ll need to pay for qualified expenses in the current tax year.

For example, if you take out $5,000 to cover tuition in December of 2018, but don’t pay that tuition until January of 2019, you could wind up with a taxable distribution from the plan.

3. Dropping a class doesn’t mean disaster

If you drop a class mid-semester, your school could send you a refund for tuition you paid for that class. If you already withdrew money from your 529 to pay that tuition, your withdrawal amount for the year could now exceed your adjusted qualified education expenses.

Don’t worry, you have an out. As long as you put that money right back into any 529 for the same beneficiary within 60 days of receiving your refund, you won’t have to pay tax on that amount. The recontributed amount won’t count against your plan’s contribution limit.

4. Know how to report 529 withdrawals

If you used all the funds reported on your 1099-Q for qualified education expenses, and the amount didn’t exceed your adjusted qualified education expenses, you don’t need to report the distribution on your tax return at all. Simply save Form 1099-Q and all your receipts showing how the funds were used in case you get audited.

If you made any taxable withdrawals during the year, you’d need to report the taxable portion as income on Form 1040 and use IRS Form 5329 to calculate and report the additional 10% penalty.

5. Learn how 529s work with education credits

If you make 529 plan withdrawals, you can still claim education credits you might be eligible for such as the American opportunity credit or lifetime learning credit. However, you can’t use the same expenses to claim both benefits.

So after you adjust your qualified education expenses by subtracting any tax-free education assistance you received, you’ll also need to subtract the expenses that figured into the calculation of your AOTC or LLC. The IRS offers this scenario as an example:

• You have total qualified education expenses of $8,300.
• You have a tax-free scholarship of $3,100.
• You’re using $4,000 in expenses to figure your AOTC.

Your calculation for adjusted qualified education expenses will be: $8,300 – $3,100 – $4,000 = $1,200. That total ($1,200) is the maximum you can withdraw from your 529 plan for the year to avoid tax and penalties.

6. Know what to do if you don’t need all the money in your 529

If you get a scholarship and you don’t need all the money in your 529 for college expenses, you have a few options. First, there is a scholarship exception to the IRS penalty.

If you receive a scholarship, you can take a nonqualified withdrawal from a 529 plan account up to the amount of the scholarship. You will owe income taxes on the earnings portion of the distribution, but you won’t have to pay the additional 10% penalty for a nonqualified withdrawal. Make sure you keep a copy of the scholarship letter for your tax records.

Second, you can change the beneficiary to another member of the family, or roll the funds into the 529 plan for the same beneficiary or member of the beneficiary’s family. That means if your parents put more into your 529 than you need, they can move excess funds into your sibling’s 529 — or into a 529 for your child, another grandchild or other family member.

Finally, you can always withdraw the funds. If they aren’t used for qualified expenses, you will owe income tax and the 10% penalty on the earnings portion, but after taxes and penalties, the money is yours to keep. This is an option if you don’t have another child or family member who can use the funds.

Bottom line

When it’s time to withdraw from your 529 plan account, you’ll want to make withdrawals the right way, and for the right expenses. Think carefully about how much you’ll need before you make a withdrawal and make sure you save any bills, receipts or other documentation with your tax records. There are many benefits to saving for education with a 529 account, but you need to know exactly what you can and can’t use the money for to make the most of the funds in your college savings plan.

Jennifer Samuel, senior tax product specialist for Credit Karma, has more than a decade of experience in the tax preparation industry, including work as a tax analyst and tax preparation professional. She holds a bachelor’s degree in accounting from Saint Leo University. You can find her on LinkedIn.