Tax Rules for Distributions from your College Savings Plan
K. Paul Hansen
If you have a child who is currently attending college, or perhaps heading to college for the first time this fall, this a great time to refresh your memory on the tax rules for withdrawing funds from your college savings accounts. If you’re withdrawing funds from your personal savings or a Roth IRA (contributions only, not earnings), then you don’t have to concern yourself with the following rules, but distributions from a Qualified Tuition Program (QTP), such as a 529 or prepaid state tuition plan (like Washington’s GET program), need to be made wisely in order to avoid unintended taxation and penalties.
The three basic W’s to keep in mind when taking money out of your QTP are Where, What and When.
Where – Eligible Institutions 101
QTP withdrawals must be used to pay for qualified expenses at an “eligible educational institution.” Per the IRS, “an eligible educational institution is generally any college, university, vocational school, or other postsecondary educational institution eligible to participate in a student aid program administered by the U.S. Department of Education.” One easy way to determine if a school qualifies is to go to the FAFSA web site (fafsa.ed.gov) and see if the school is listed. If you have high school age children who are attending an eligible institution through the Running Start program, those college course expenses can also be paid for with QTP funds if they meet all of the other requirements listed below. Additionally, thanks to the Tax Cuts and Jobs Act of 2017, you can now use QTP withdrawals to pay for up to $10,000 per year of K-12 education costs at private, religious, or public schools.
What – Qualified Expenses 101
Withdrawals from a QTP must be for “qualified education expenses” in order to avoid taxation of any kind. These expenses can be incurred for both undergraduate and graduate level schooling. While some qualified expenses are obvious, others are not. If you have significant funds in your QTP, and are worried about having funds left over (and potentially taxed) after your child completes their schooling, then maximizing your annual tax free distributions means taking advantage of paying for every possible qualified expense with QTP withdrawals (but always make sure to have enough out-of-pocket costs not covered by QTP funds in order to maximize the benefit of any available tax credits that you qualify for.)
Here are the obvious expenses that qualify:
- Mandatory fees
- Textbooks and supplies required for courses
- Room and board paid for housing owned and operated by the school for students enrolled at least half time (note: room and board are qualified expenses for QTP purposes, but are not qualified expenses for tax credit purposes)
Here are some less obvious expenses that qualify (be sure to keep records that justify these expenses):
- Some expenses required for participation in an apprenticeship program, registered and certified with the Secretary of Labor under section 1 of the National Apprenticeship Act
- Up to $10,000 paid as principal or interest on a qualified student loan
- Room and board paid for living off campus (student must be enrolled at least half time)— however, your QTP withdrawals for this cost cannot exceed the actual costs or the allowance for room and board amount that was included in the “cost of attendance” calculation posted by the school for financial aid purposes (this can generally be found on the school’s web site)
- Computer technology (laptop, printer, internet fees, etc.), if required for enrollment or attendance at an eligible institution
Lest you begin to think all of your child’s living expenses qualify for QTP withdrawals, here are a few common costs that do NOT qualify:
- Travel and transportation
- Computers and other equipment that aren’t required as a condition of enrollment
- Sporting events and entertainment (even school related events)
- Fraternity and sorority fees
When – Withdrawal Timing 101
While most parents are savvy to the “Where” and “What” rules related to QTP withdrawals, the “When” can still trip them up. The most likely reason for this confusion is the difference between a school’s academic year (fall to spring), and your personal tax basis year (January to December). When you’re making QTP withdrawals, you must make sure that they occur in the same calendar year as the payment of the qualified expense. This can get tricky around the end of December when paying for classes and living expenses that don’t start until January. Keep in mind that you are a “cash basis” taxpayer, so make sure that the QTP withdrawal and your cash payment for costs are in the same calendar year. One way to eliminate the risk of such a timing mismatch is to have the funds issued directly from your QTP to the school, rather than as a reimbursement to you for expenses paid or payable.
Example: Your child’s spring classes begin January 2, 2021. The college housing deadline for payment of $4,000 for the spring room and board fees is December 31, 2020 (so you pay it in December), but the $6,000 owed for spring tuition isn’t due until January 15, 2021 (so you pay it in January)—in this case, you should not withdraw $10,000 from your QTP in either 2020 or 2021. Instead, you must make a $4,000 withdrawal in 2020, and a $6,000 withdrawal in 2021, in order to match the withdrawal with the calendar year in which the qualified expenses were actually paid.
In summary, knowing the three W’s of QTP withdrawals will help you maximize your ability to utilize these funds for qualified expenses while minimizing the risk of incurring any unintended tax or penalties on the withdrawals.
K. Paul Hansen, CPA, CFP®