A 529 plan is an education savings plan that earns tax exempt yields. (i.e. dividends/capital gains). 529 funds earn dividends through investments in relatively conservative (safe) portfolios and most plans allow you to pick from an array of investments from safe (low risk) to more aggressive (higher risk) funds. You can withdraw from a 529 plan at any time to fund trade school or college coursework for your own education, your children’s education (or any designated beneficiary). We do not promote any particular 529 plan; however, there are many from which to choose. Georgia is an excellent 529 state!
529 Plan Facts:
Each year that you withdraw from your 529 plan you will receive a form 1099-Q tax form from the fund provider (broker). You may need this form to complete your personal tax return.
Each year that you wish to withdraw and use 529 funds from your account, you will be required to estimate the maximum 529 withdrawal required to cover all education expenses for that calendar year. If you withdraw an amount beyond what is necessary to cover education cost + room and board, you will be taxed and assessed an additional 10% penalty on a portion of the excess withdrawal…unless you notify your 529 provider and return the excess amount.
Over a 5 year period, you and your spouse contribute a total of $50K into a 529 plan. After five years the total 529 account balance (contributions + gains) = $62,000. At the beginning of the 6th year your child begins college and you project total ANNUAL cost as follows: classes + fees + books + ALLOCABLE ROOM AND BOARD EXPENSE totaling $27,500.
All colleges will provide you with anticipated OFF-CAMPUS room and board expense. This is called ALLOCABLE ROOM AND BOARD EXPENSE. You will use the school’s calculation for ALLOCABLE ROOM AND BOARD EXPENSE, regardless of how much you actually spend for off-campus room and board.
If your child will be living ON CAMPUS, you’d simply include in your total cost the actual room and board cost from the college’s price list for dorm room and meal plans.
1. If your child will not receive scholarships or grants, you can withdraw the entire $27,500 projected annual cost from your 529 plan, tax exempt.
2. If you projected $27,500, but your child’s actual expenses are $24,000 and you did not re-contribute the additional $3,500 back to the 529 plan, you would be subject to tax AND a 10% penalty on the earnings portion of the excess $3,500. The taxable earnings portion of the $3,500 over-withdrawal would be calculated as follows by your tax accountant (or self-prep software) after entering all relevant data from your 1099-Q tax form.
[total 529 plan gains]/[total 529 balance at year end] = [529 average gain %]
$12,000/$62,000 = .1935 (19.35%)
[529 average gain %] x [Total over withdrawal] = [taxable over withdrawal]
.1935 x $3,500 = $677.25 (taxable amount)
In this scenario you’d pay tax (when you file your tax return) at your normal income tax rate + 10% penalty on the $677.25 earnings portion of the $3,500 over-withdrawal. At a typical 33% marginal tax rate + 10%, tax and penalty would be $291.
3. If your projection of $27,500 total annual college expense were correct and you withdrew that amount from your 529 plan, but later discovered that your child received $3,500 in scholarships and grants for the year, you would pay tax on the $677.25 gains portion of the $3,500 over-withdrawal; however, because the over-withdrawal is due to receipt of scholarships and grants, the additional 10% penalty WOULD NOT apply. Therefore, if you child receives a full ride scholarship, you can withdraw all 529 funds without penalty and pay tax only on the 529 account earnings (yields/capital gains). This is exactly how traditional IRAs are taxed at retirement.
American Opportunity Credit (AOC)
Although the gains portion of 529 withdrawals cannot be counted towards the AOC, if your income is between $160,000 – $180,000 (Married Filing Jointly), the contribution portion of your 529 withdrawals + any other out-of-pocket paid towards classes, fees and books, can be used to calculate your AOC.