Qualified 529 Spending (2006-08-28)

Qualified 529 Spending

(2006-08-28) by David John Marotta

The University of Virginia is back in session and Charlottesville was crowded with students last week stocking up for college. Total cost for attendance this year at UVa is estimated at $17,764 for Virginians and $35,644 for non-residents. While most of the bills can be paid from a 529 college savings account, a couple thousand dollars in expenses will not qualify.

My son, our oldest child, is starting college this fall as a film major at the North Carolina School of the Arts. He has two 529 plans which will help cover the costs of becoming the next M. Night Shyamalan.

With careful planning and a 529 college savings plans, you can reduce the cost of college by taking advantage of the plan’s tax-free benefits. Understanding what qualifies for a tax free withdrawal is important in order to receive the maximum benefit from the plan.

All that stuff for the dorm room and even that new laptop computer may not qualify as higher education expenses, according to Uncle Sam. In fact, that pack of no. 2 pencils probably won’t make the cut. Understanding what qualifies and keeping careful records is important if the IRS questions your withdrawals.

Qualified tuition programs like 529 savings plans have incentivised saving for college much like the IRAs have done for retirement. The simple beauty of these tax-efficient plans allows investments to grow tax-free and permits tax-free withdrawals on qualified education expenses like tuition, fees, books, supplies and - in most cases - room and board.

The IRS defines a tax-free 529 distribution as a qualified higher education expense at an eligible educational institution. But to qualify for the tax-free benefits, your withdrawal will have to pass two important tests.

First, it must be incurred for the purpose of education at an eligible institution. Eligible institutions include most colleges and universities in America, specifically those qualified to participate in the Department of Education’s student aid program. Some post-secondary institutions outside the US also qualify. To check for the list of eligible institutions, visit http://www.fafsa.ed.gov/fotw0607/fslookup.htm.

Second, the withdrawal must be for tuition, fees, books, supplies, and equipment required for enrollment or attendance at an eligible educational institution. For degree seeking students attending at least half-time, reasonable room and board expenses are also considered a qualified expense.

At first glance, it would seem just about anything might pass this second requirement. So, why can’t you reimburse yourself for that pack of pencils? If you were reading carefully, you noticed the key to passing the second test rests in one little word: "required."

For example, buying a textbook required for class would be a qualified expense. But additional reference materials, such as a dictionary or thesaurus, may not be. And, those pencils you bought cannot be considered a qualified expense unless they are specifically required for attendance. So, forget about reimbursing yourself for all that cool stuff for the dorm room.

Regarding the laptop you purchased, keep your fingers crossed. If the computer is required for class or for attendance at the school, it can pass as a qualified withdrawal. But, as demonstrated in the tax court case of Gorski v. the Commissioner, buying a laptop to save your daughter from waiting in line at the computer lab will not pass muster. In our case we are fortunate since NCArts considers a computer loaded with film editing software a requirement for attendance.

There are still plenty of gray areas. But, thus far, the US tax courts have taken a narrow interpretation of the term "required." All non-qualified withdrawals are subject to a 10 percent penalty in addition to federal and state income taxes on earnings. And while this may mean you pay out of pocket for the new bedding, mini fridge, and the pack of no. 2 pencils, the tax savings offered for those qualified withdrawals should be worth your troubles.

So, how do you go about getting your money?

529 accounts do not issue debit cards or checks. And, although plans vary by state, making a withdrawal can be as easy as calling your investment advisor or the investment company directly. Funds are typically sent by check to the account owner, to the account beneficiary, or to the college or university. Withdrawals can be made at any time by the account owner. However, the owner is responsible for determining whether an expense is qualified or not and for maintaining documentation for all qualified withdrawals.

Distribution requests involving large sums or funds made out to a third party will likely require the account owner to complete a distribution form accompanied by his or her guaranteed signature. With CollegeAmerica’s 529 accounts, withdrawals cannot exceed $75,000 per year, and no more than $5,000 can be payable to the beneficiary.

Because there is no restriction on how long the money must be in the account before being withdrawn, Virginia residents can take a $2,000 state tax deduction each year by simply putting their money into a 529 account one day and withdrawing the same amount the next day. While they miss out on the years of tax-free compounding, they still benefit from the college funding deposit. If college expenses are more than $2,000 they can open multiple accounts and get a $2,000 state tax deduction on each account or roll their $2,000 deduction forward each year until it is used up.

The rules associated with college funding are not simple or rational, and you should consult a tax expert before taking any action. Coordinating tax-free 529 withdrawals with other tax benefits may be tricky. The bottom line is this: Uncle Sam prohibits double-dipping. You may take a qualified 529 withdrawal and a tuition deduction or education credit in the same year. However, the benefits cannot be taken for the same expenses. Tax-free distributions from a 529 account and a Coverdell Education Savings Accounts can be taken in the same year but, again, cannot be taken for the same higher education expenses.

To find a fee-only financial planner in your area who can assist with your college planning needs, visit www.napfa.org.

from http://www.emarotta.com/article.php?ID=193