529 plans help you save for higher educational costs. Though you don't get a federal tax deduction for contributing, the IRS doesn't tax the growth in the account until you take the distributions. Planning your distributions can help you avoid paying any taxes on the distributions, or at least be prepared for the amount you have to pay.
When you take a distribution, you have to split the distribution between contributions and earnings. For example, if you take a $4,000 distribution and your account has 75 percent contributions and 25 percent earnings, $3,000 of your distribution comes from contributions and $1,000 comes from earnings. These amount should be reported to you on Form 1099-Q, with the total in box 1, the earnings in box 2, and the contributions in box 3.
Qualified distributions from a 529 plan don't get reported on your income tax return because they're tax-free distributions. In order to be qualified, you have to have qualified educational expenses, which for 529 plans include tuition, fees and supplies at post-secondary schools, including colleges, universities and trade schools. In addition, if you're enrolled at least half-time, room and board expenses also qualify. For example, if 14 credit hours is considered full-time enrollment, you can include room and board costs as qualifying expenses if you're enrolled in at least seven credit hours.
No Double Counting
You can't count expenses for both an educational tax break, such as the lifetime learning credit, American opportunity credit or tuition and fees deduction, and as qualified expenses for a 529 plan distribution. For example, if you have $11,000 in qualified expenses but you use $10,000 to claim the lifetime learning credit, you only have $1,000 of expenses for the purposes of 529 plan distributions. Therefore, consider which benefits will give the largest tax breaks when deciding whether to use your expenses to claim a tax credit or deduction.
If you take distributions from a 529 plan and don't use them for qualified expenses, you have to pay taxes on the earnings. In addition, you have to pay a 10 percent additional tax penalty unless an exception applies. The exceptions for 529 plans include if you receive a scholarship or use the qualifying expenses for an education tax break, are attending a U.S. military academy or are permanently disabled. If an exception applies, you're only responsible for the income taxes, but won't owe the penalty.
Mark Kennan is a writer based in the Kansas City area, specializing in personal finance and business topics. He has been writing since 2009 and has been published by "Quicken," "TurboTax," and "The Motley Fool."