It's tempting for parents to withdraw funds they've saved in a 529 plan, a higher education savings account with tax benefits, if their son's or daughter's freshman-year education costs are entirely paid for by scholarships, grants, and tax credits. But Ryan Law CFP®, director of the University of Missouri's Office for Financial Success, says it's not always a good idea.
Availability of funds can vary from year to year. In certain years, 529 plan distributions may be needed to supplement other forms of college funding, Law says. Other years, he notes, there may be enough funding without 529 plan funds.
Before parents withdraw their first dollar from 529 plans, they should follow these three steps:
1. Start with the cost of attendance: The cost of attendance, according to the Department of Education, is the total cost of going to school—from tuition to housing. This number is available on university websites via cost of attendance calculators, such as this one from Louisiana Tech University. But parents can get a better estimate by discussing their son's or daughter's current or future college budgeting with someone in the student money management or financial aid office, Law says.
For instance, the university cost of attendance calculator doesn't track if particular majors require more lab fees or equipment charges, he says. Compare the revised college costs estimate with total grants, scholarships, and tax credits parents expect this year, Law says. Then supplement with 529 plan distributions as needed to make up the difference for qualified higher education expenses, education-related costs allowed to be paid with 529 distributions.
2. Consider factors affecting future availability of funding: Once you know if this year's college expenses are covered by grants, scholarships, grants, or tax credits, you can consider future years, Law says. He notes that availability of funding can change annually for a variety of reasons.
For example, scholarships that students receive one year may not be available the next. Four-year scholarships can even be rescinded; it's important for students and parents to know what can cause a student to lose continuation of a four year scholarship, Law says. For instance, Law was among 20 students who received a certain college scholarship during his undergraduate career. In order for his scholarship funds to renew, he had to maintain a certain GPA and complete a community service requirement.
Availability or amounts of federal grants and tax credits can also change at the discretion of Congress, Law says. In addition, changes in family income affect eligibility.
3. Avoid emptying 529 plans until education is complete: Parents aren't assessed a tax penalty on money withdrawn for a non-educational purpose equal to or less than the amount of scholarships or grants received within the same tax year, but they do have to pay income taxes on earnings, says Jason Washo, a personal financial specialist and certified public accountant.
The income tax paid is based on the parents' tax bracket, Washo says. For example, if a parent were to withdraw funds from a 529 account with $25,000 left in it—$12,500 was from money the parent contributed and $12,500 was from investment growth—at the end of a child's college career, he or she would be charged income tax on the half from earnings, Washo explains.
If the parent is in a 25 percent tax bracket—between $70,700 and $140,700 in income for 2012—the tax is slightly more than $3,000. If $10,000 of the $25,000 was withdrawn because of scholarships received in previous tax years, there would be an additional 10 percent penalty, equaling $500, on the portion from earnings. But the parent is still left with just under $21,400 that they can spend on anything they want, Washo notes.
Reyna Gobel, frequently quoted as an expert on student loans and college costs, is the author of "Graduation Debt: How To Manage Student Loans And Live Your Life" and "How Smart Students Pay for School: The Best Way to Save for College, Get the Right Loans, and Repay Debt." She has appeared on PBS's Nightly Business Report and speaks regularly at CollegeWeekLive.