Three 529 withdrawal penalties to avoid

Steer clear of these common college savings mistakes

Three 529 withdrawal penalties to avoid

Paying for college can be expensive, but the tax-advantaged status of 529 plans can help your dollars go further. There are a few key restrictions when it comes to using your 529 distributions, however. Ignore the rules, and you could find yourself looking at some pricey penalties. Read on to see three of the most common 529 mistakes — and how to avoid them.

529 mistake No. 1: Using funds for nonqualified expenses

You know that a 529 plan will pay for many of your child’s educational costs — but before you withdraw any funds, dot those i’s and cross those t’s by verifying that your purchases fall under the list of qualified 529 expenses.

Some of the most common qualified items include:

  • Tuition and fees
  • Books, supplies and equipment
  • Expenses for “special needs” services directly related to enrollment/attendance
  • Room and board incurred by students who are attending at least half time
  • Computers, peripherals, software, internet access and related services during enrollment/attendance

On the flip side, many of the costs we associate with college are not considered qualified 529 expenses. These include:

  • Mobile phones
  • Travel to and from school
  • Student loan payments

As you can see, 529 plans can be used for a wide range of educational costs, but they don’t cover everything. Taking the time now to double-check your expenses can save you from incurring any surprise penalties down the line.

529 mistake No. 2: Taking tax credits on your 529 withdrawals

Chances are, you’re aware of the American Opportunity Tax Credit (AOTC), which offers up to $2,500 annually for use toward qualified education expenses. Sound familiar? Much like 529 plans, the AOTC can go a long way in helping parents cover the costs of a college education — but it’s important to note that you cannot claim the AOTC on any expenses paid from a 529 plan. In other words, you’re only permitted to use one tax benefit per expense. Take both, and you could face some costly tax penalties.

Balancing the AOTC and a 529 plan can be tricky, but your financial advisor can help your family find the right strategy for your needs.

529 mistake No. 3: Taking early withdrawals

Whether your child has put college on hold or received a full scholarship, you may find yourself with a fully funded 529 account that isn’t being used as originally planned. Easy enough to apply that money toward other expenses, right? Think again.

Withdrawing 529 funds for anything except qualified educational expenses incurred through enrollment at an eligible institution generally carries an automatic 10% penalty, along with any state penalties that may apply.1 Ouch! Instead of taking the hit with an early withdrawal, why not consider reallocating your 529 funds to a new beneficiary? As the account owner, you can choose to transfer the beneficiary to another child, a niece or nephew, a grandchild, your spouse or even yourself, making it possible for someone else in your family to get that higher education you’d been saving for — without any costly tax penalties.

Making the most of your 529 strategy

529 plans can make a big difference in helping you pay for your child’s college education, as long as you play by the rules. Talk to your financial advisor, who can help you create a plan for college savings and a distribution strategy that will help you steer clear of expensive tax penalties.

Read more about 529 college savings plans.

1 Earnings on non-qualified withdrawals may be subject to federal income tax and a 10% federal penalty tax, as well as state and local income taxes. Tax and other benefits are contingent on meeting other requirements and certain withdrawals are subject to federal, state and local taxes.

Important information

Blog header image: sonsam/Shutterstock.com

Thomas Rowley

Director, Retirement and Education Strategies

Thomas Rowley is director of retirement and education strategies and one of Invesco’s most frequently requested speakers. He provides analysis of the evolving retirement landscape and develops actionable strategies to help investors and financial advisors maximize their retirement-planning opportunities. Mr. Rowley regularly shares his insights online at invesco.com/us in addition to his speaking engagements.

Mr. Rowley’s insights reflect more than 20 years of experience in the investment industry. He translates his comprehensive knowledge of retirement planning into lively, clear explanations of the complexities of legislative, investing, tax and social issues.

Mr. Rowley shares his analyses of retirement-related issues through regular personal appearances, continuing education webinars and Web-based commentaries.

Mr. Rowley has been director of retirement business strategy since 2010. Prior to joining Invesco in 2010, he was in charge of individual retirement plan products and Retirement Marketing at Van Kampen.

Prior to joining Van Kampen in 1996, he was a 401(k) regional sales director with an investment firm. His experience also includes seven years in retirement plan operations and three years as head of a brokerage firm’s retirement help desk. He began his career in the Treasury bond futures pit at the Chicago Board of Trade.

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