Dear Liz: As a parent of a college freshman, I rushed out and closed out one of my son’s 529 college savings plans, thinking I would use the money to pay his expenses for the whole year. It turns out I will have pulled out $6,000 too much in 2010, because I was charged only for one term of room and board. Can I prepay the extra in 2010 for 2011 room and board and tuition as a valid college expense to avoid any 2010 taxes on the extra funds? If not, do you have any suggestions to avoid 2010 taxes?
Answer: Withdrawals from a 529 plan are trickier than many people think. They’re tax free only to the extent that you pay qualified higher education expenses in the same calendar year that you take the distribution — and that other tax breaks aren’t used.
Qualified expenses include tuition, fees, books, supplies, equipment and additional expenses for “special needs” beneficiaries. Qualified expenses do not include insurance, sports or other activity fees, transportation costs or the purchase of a computer, unless it’s required by the school.
If you pull out too much, you have to pay income tax and a 10% federal penalty on the earnings portion of the excess withdrawal. (For example, if your account totaled $10,000, and $6,000 was earnings while $4,000 represented your original contributions, you would pay the penalty on 60% of any excess withdrawals.)
There’s another way you might get hit. If you were planning to use an education tax credit, such as the Hope or Lifetime Learning credit, you would have to deduct from your qualified expenses the amount used to generate the credit. Let’s say you used $5,000 in tuition expenses to generate a $1,000 Lifetime Learning credit. That $5,000 would have to be deducted from your qualified expenses total, which would further reduce the amount of your 529 withdrawal that’s tax free. You wouldn’t have to pay the penalty on the excess withdrawal created by the tax credit adjustment, but you would have to pay income tax on any earnings.
Now the good news: You are allowed to prepay next year’s costs to help boost your qualified expenses total. If it’s been less than 60 days since the withdrawal, you also would be allowed to roll the excess distribution over into a new 529 account.
Fortunately, you discovered the problem before the end of the year. If you’d learned about the problem only when you started preparing your tax return next spring, as many people do, it would be too late and you would be stuck with the extra tax and penalty.