Section 529 plans are a tax-favored tool to help families save money to pay for qualified education expenses. Many people set up Sec. 529 plans when their kids (and grandkids) were born or entered preschool, and then let the account go on “autopilot” until the funds are needed.

Before you start taking withdrawals, it’s a good idea to review the tax implications. Withdrawals are tax-free in most cases — but not always.

Tax Forms

Contributions are made to Sec. 529 plans on an after-tax basis. In other words, contributions aren’t deductible on your federal income tax return. There’s no income limitation to take advantage of these plans — even billionaires can participate. Plan contribution maximums are set by each state. Contributions in excess of the annual gift tax exclusion ($15,000 per person per spouse for 2021) should be reported on a gift tax return. There’s also an option to “super-fund” 529 plan contributions.

When you withdraw money from a Sec. 529 college savings plan, you’ll receive a Form 1099-Q, “Payments from Qualified Education Programs,” for that tax year. If a withdrawal is paid to you as the account owner or plan participant, the form will be sent directly to you. If the payment is made to the account beneficiary or the college, the form will be sent to the account beneficiary. The IRS will also receive a copy of this form. Be sure to report the distribution on the tax return for the person whose name is shown on the 1099-Q to avoid an unnecessary notice from the IRS.

Basis Contributions vs. Earnings

Form 1099-Q shows the total amount withdrawn from the Sec. 529 account during the year. It also breaks down withdrawals between:

• Return of basis, and
• Account earnings.

Withdrawn basis contributions are always tax-free. Withdrawn earnings won’t be taxed if the money is used to pay for qualified education expenses. Examples include:

• Tuition and fees,
• Room and board, if the student is enrolled for at least half the full-time academic workload for his or her course of study,
• Book and other course materials, including computers, and
• School-related special needs services.

Note: Under current tax law, Sec. 529 plans have been expanded to allow withdrawals of up to $10,000 per year (tax-free) per student to pay for tuition at a public, private, or religious K-12 school.

Qualified education expenses also must be adjusted for costs covered by:

• Pell grants,
• Tax-free scholarships,
• Fellowships,
• Tuition discounts,
• Veteran’s education assistance,
• Tax-free employer educational assistance program, and
• Federal tax breaks, such as the American Opportunity Credit or the Lifetime Learning Credit.

Sec. 529 plan earnings withdrawn and spent on unqualified expenses — such as a new car or a vacation after graduation — are subject to income tax and a 10% penalty.

To avoid the tax hit, you might decide to transfer unused Sec. 529 plan earnings that remain after graduation to another account for a younger child or grandchild. You could also transfer the remainder to your own Sec. 529 account if you decide to go back to school.

Ready, Set, Withdraw

If you’re planning to withdraw funds from a Sec. 529 plan to pay for qualified education expenses this fall, don’t just assume that the payment will be federal (or state) tax free. Our tax specialists can help you identify and, if possible, minimize any adverse tax consequences. We can also discuss other college-saving tools and education-related tax breaks for you to consider.