Avoiding Common 529 Plan Mistakes | Maximize Benefits & Tax Savings

It’s never to early to start stashing away cash for your child’s education, especially with tuition costs steadily increasing. For the 2012-2013 school year, CollegeBoard estimated the average annual cost of tuition at a public four-year school was $17,860, up 4.2 percent from the previous year. Private schools are even pricier, with an average tuition rate of  $39,518 per year.
For many parents, one of the easiest ways to plan ahead for these costs is to set up a 529 plan. At least one 529 plan is offered in all 50 states and some states sponsor more than one plan. These plans offer several benefits over other types of education savings vehicles, including high contribution limits and tax-free qualified withdrawals. While 529 plans are relatively easy to manage, parents should avoid these common mistakes.

1. Choosing the Wrong Plan Type

There are two types of 529 plans you can set up: a prepaid tuition plan and an education savings account. A prepaid tuition plan lets you buy future college credits at a locked-in price. The money that goes into these plans is invested in a pool that you can draw from when it’s time to pay for your child’s college expenses. The idea is that by purchasing credits in advance you won’t be impacted by significant increases in tuition rates. While a prepaid tuition plan may save you money in the long run, not every state guarantees your returns. This means that if the plan investments don’t grow as expected, you might find yourself coming up short when it’s time for your child to go to school. With an education savings account, you don’t get the advantage of locked-in rates but you can control how the money is invested in order to get the best returns.

2. Paying for Unqualified Expenses

The IRS allows you to withdraw money tax-free from a 529 plan for qualified education expenses. This includes tuition payments, fees, books, supplies, and equipment. You can also use 529 money to cover certain expenses for a special needs student or room and board costs if your student is enrolled at least half-time. In addition, the money can only be used for students who attend an eligible institution, which means any school that’s eligible to participate in federal student aid programs. One of the biggest mistakes you can make with your 529 plan is using the money to pay for unqualified expenses, like transportation, clothing or medical care. If you take money out for anything other than education expenses, the IRS will tax the earnings part of the distribution. You’ll also have to cough up an additional 10 percent early withdrawal penalty if you’re under age 59 1/2.

3. Mistiming Your Withdrawals

When you take money out of a 529 plan is just as important as what the money is used for when it comes to your tax filing. If your child plans to apply for financial aid or is eligible to receive grants or scholarships, you’ll want to hold off on making withdrawals until you figure out exactly how much money you’ll need. If you take too much money out of your 529 plan, you’ll end up having to pay taxes on the earnings for the excess amount, not to mention the 10 percent early withdrawal penalty. Timing is also important for parents who plan to take advantage of key tax credits, such as the American Opportunity Tax Credit and the Lifetime Learning Credit, or the tuition and fees deduction. You can’t claim these credits or the tuition and fees deduction for the same expenses that you used 529 plan money for. You’ll need to factor in which credits or deductions you plan to claim before tapping your 529 account to make sure that you get the biggest tax benefit.

4. Forgetting About the Gift Tax

The IRS assesses a special tax on financial gifts above a certain amount, including money you put into your child’s 529 plan. For 2013, you could gift up to $14,000 to someone without having to pay the tax. For married couples, the limit doubles to $28,000. If you’re putting in more than the annual exclusion limit, you could end up owing taxes on the difference. If you or another family member wants to put a large chunk of change in your child’s 529 account all at once, you can opt for the five-year election. Going this route allows you to put in five times the annual exclusion limit all at once. As long as you don’t make any other taxable financial gifts to your child during the five-year period you won’t owe any gift tax on the money.

5. Skipping the Fine Print

While 529 plans are fairly straightforward, not all plans are created equally. Before you commit to setting up one of these accounts you need to read over all the plan details to make sure it’s right for you. Specifically, you’ll want to pay attention to the plan’s contribution limits, investment choices and the fees that go along with maintaining the account. It’s also a good idea to familiarize yourself with the IRS guidelines regarding 529 plans and the different tax benefits for education. Knowing what to expect beforehand can ensure that you and your child get the most bang for the buck when it comes to paying for college expenses.