Poor timing of 529 withdrawals can cancel tax benefits

by Grace

529 funds must be withdrawn and used within the same year that expenses are incurred to preserve tax benefits.

Question: My daughter’s college is offering a discount if you prepay in year one for all four years. Can we use 529 funds to pay all of her tuition up front even though she’ll still be in school for another few years?

Answer: In general, 529 distributions must be used to cover qualified college expenses incurred in the same tax year in which the distribution is made; otherwise, taxes and a penalty apply. The scenario you describe falls into something of a gray area given that you would be using 529 assets to pay for tuition–a qualified expense–but paying for services to be provided not only during the current tax year but in future tax years as well.

Such a scenario isn’t specifically addressed in the IRS rules governing 529 expenditures, but Mark Kantrowitz, publisher of the college-planning siteEdvisors.com, says the way the rules are written suggests that it is not just when qualified expenses are paid that matters but when those expenses are incurred. “In general, the IRS interprets tax law as applying to income and expenses during the tax year except if explicitly stated otherwise,” Kantrowitz says.

The bottom line is you’d be wise to consult a tax professional before prepaying all four years. Even if he or she recommends only counting the current year’s tuition payment as a qualified expense, you could still pay all four years at once to take advantage of the discount. Just keep in mind that if doing so requires using additional 529 funds, you may end up owing taxes on the earnings portion of any nonqualified distributions plus a 10% penalty, and those costs could eat into–or erode entirely–the prepayment discount.

Morningstar offers more advice about avoiding the pitfalls in timing your 529 withdrawals.

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Adam Zoll, “529 Owners, You Must Remember This”, Morningstar, February 3, 2015.

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2 Comments to “Poor timing of 529 withdrawals can cancel tax benefits”

  1. This leads me to wonder when schools require payment.

    For example, one school I attended was on the quarter system, with winter quarter classes starting right after New Year’s Day. IIRC, we had to be registered, and have paid our tuition for that quarter, before the end of the immediately preceding December. Would this then preclude the use of a 529 distribution to pay for winter quarter tuition?

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  2. It can be confusing, particularly the use of the term “incurred”. Here’s my understanding of how the winter quarter situation would be treated. The expenses, although they are for the winter quarter of the following year, are actually incurred in the previous year because of the school’s payment deadline. This is markedly different from the situation in the Q&A above where payments are required for years in advance.

    However, it can get messy and the IRS may question these payments. For tax credits there is explicit IRS language detailing how the pay in December for January attendance is fine for tax credits, but as far as I know there is no such language for 529s.

    I have only read about this, but do not have personal experience with this issue. This is a case where either a tax accountant or even the school could advise on a specific situation.

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