Section 529 Plans: Taking Qualifying Distributions

In the somewhat odd world of Section 529, where taxability doesn't follow the ownership of the account (remember, you own the account even if you had to file gift tax returns for giving the money that's in the account away to the Section 529 plan), the beneficiary (not the owner) bears all the income tax consequences of distributions made to, or on the behalf of, him or her.

Depending on the state and the type of plan you own, distributions are made directly from the plan to the school (this most likely occurs with a prepaid tuition plan) or to you or your designated beneficiary. If checks are being written to you or your beneficiary, make sure that you create a good paper trail, showing exactly what qualified expenses were paid with the distribution amounts. Remember, it's not enough that you have a qualified student and that student is actually attending an institution of higher learning; you also need to use the distributions from your 529 plan to pay those expenses.

Assuming that (a) your designated beneficiary is now a qualified student and (b) that student is now incurring qualified expenses, you now need to figure out just how much of a distribution you should make from your Section 529 plan. In calculating this number, here's what you need to do:

• Estimate how much the qualified expenses are likely to be, not only this year but also for the remainder of this student's education. If you think that your savings may be a bit short, spending them all in one or two years may make sense if you need to make up the balance by using current income. Spread them out over the lifetime of the diploma or degree your designated student is working toward. If you think that your student may qualify for need-based financial aid, spending down the amount in the 529 plan in the first year or two may be to your advantage down the road.
• Explore what other resources are available to make up any gaps in funding. If you don't have the total cost of all qualified expenses sitting in your Section 529 plan, you'll probably have to pay some portion of qualified expenses from your current earnings. If you also have a Coverdell Education Savings Account for your student, a portion of qualified expenses may be paid from there, as well.
• Consider any outright grants and scholarships that your student may be entitled to. To the extent that any sort of scholarship, fellowship, or grant money is available, it always offsets qualified tuition expenses first. The income portion of any 529-distribution amounts that are not used to pay qualified educational expenses is generally treated as taxable income to the recipient.
• If you want to take the Hope or Lifetime Learning Credit, you need to pay at least some qualified expenses using real, taxable income. This includes wages, taxable interest and dividends, rental income — you get the picture. You have to admit that this idea makes sense; you really shouldn't get a tax credit for expenses that you paid with tax-exempt income.

If, at the end of the day, you've taken too large a distribution from your Section 529 plan, well, the world as you know it doesn't really end. To the extent that the distribution exceeds the amount of qualified education expenses, the income portion on the overage will be taxed at the designated beneficiary's tax rate, which is usually lower than your own. In addition, unless the excess distribution amount is one of the qualified exceptions, the student will also pay an additional 10 percent penalty on the income portion only of the nonqualified amount.

Taking nonqualifying distributions from a Section 529 plan will cost your beneficiary money, but the sky won't fall in. Just don't make a habit of it.