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The Short Answer

529 Owners, You Must Remember This

College-savings plan assets must be withdrawn the same year expenses are incurred if you want to avoid taxes, penalty.

A recent Short Answer article responding to readers' questions about 529 college-savings plans elicited even more new and interesting questions from readers. So, let's do it again.

Question: My daughter's college is offering a discount if you prepay in year one for all four years. Can we use 529 funds to pay all of her tuition up front even though she'll still be in school for another few years?

Answer: In general, 529 distributions must be used to cover qualified college expenses incurred in the same tax year in which the distribution is made; otherwise, taxes and a penalty apply. The scenario you describe falls into something of a gray area given that you would be using 529 assets to pay for tuition--a qualified expense--but paying for services to be provided not only during the current tax year but in future tax years as well.

Such a scenario isn't specifically addressed in the IRS rules governing 529 expenditures, but Mark Kantrowitz, publisher of the college-planning site Edvisors.com, says the way the rules are written suggests that it is not just when qualified expenses are paid that matters but when those expenses are incurred. "In general, the IRS interprets tax law as applying to income and expenses during the tax year except if explicitly stated otherwise," Kantrowitz says.

The bottom line is you'd be wise to consult a tax professional before prepaying all four years. Even if he or she recommends only counting the current year's tuition payment as a qualified expense, you could still pay all four years at once to take advantage of the discount. Just keep in mind that if doing so requires using additional 529 funds, you may end up owing taxes on the earnings portion of any nonqualified distributions plus a 10% penalty, and those costs could eat into--or erode entirely--the prepayment discount.

Question: My son had significant qualified 529 expenditures at the end of 2014, but there was insufficient time to request a withdrawal from his 529 plan to pay for them. Can we make a 2014 withdrawal now, in 2015, or use his 2015 withdrawaltoward these last-minute 2014 expenses?

Answer: Unfortunately, the answer is no in both cases. As discussed in the previous question, 529 distributions must be made during the same tax year in which qualified college expenses are incurred. This typically requires a bit of advanced planning, particularly if the beneficiary is likely to incur large expenses at the end of the year. You cannot use a distribution in early 2015 to pay for those late 2014 expenses.

Question: Can funds in a 529 plan be used to help pay for the beneficiary's student loans while he is still enrolled in college? What about after he graduates? 

Answer: As discussed previously in this Short Answer, 529 assets cannot be used to pay off student loans, and that's true regardless of whether the beneficiary is still in school or has graduated. Once again, this comes down to the fact that assets must be distributed in the same year that qualified expenses are incurred or taxes and a penalty may apply.

Your question, which was asked by a few readers, raises another point, however: If the beneficiary still has 529 assets remaining in his or her account, why take out loans rather than using that money to pay those expenses? By taking out a loan, you are likely paying fees and interest that you could avoid by tapping your 529 assets first. Once those 529 assets are exhausted, you may have no choice but to take out loans. But taking out loans when you still have money available--money, in fact, that must be used for college expenses to avoid having to pay taxes and a penalty on it--doesn't add up.

Question: Our daughter has been out of college for two years, and we did not use any of her 529 plan funds to fund college expenses. We paid for all her expenses. Can we withdraw funds now? If so, are there any tax implications?

Answer: Here's an example of good intentions leading college savers astray. Perhaps you thought that by not spending down your daughter's 529 assets and paying for college out of pocket that you were doing her a favor. Maybe your plan was to let her keep the money in the account as a graduation gift, or to use it for graduate school. Whatever the reason, unless you use the money to cover qualified expenses in the same year it is withdrawn, it is subject to taxes and a penalty. Saying that you are taking distributions now for expenses incurred two or more years ago won't work.

If you do end up taking money out of the account, be aware that the earnings portion of any nonqualified 529 distributions is taxable at the account owner's ordinary income tax rate rather than at the lower long-term capital gains rate. The 10% penalty is added to that amount (although it is waived if the beneficiary dies or becomes disabled).

There is a way to avoid paying these taxes, however. You could transfer the unused 529 assets to the account of a sibling or another beneficiary who is part of the extended family (read this article for more about this approach). That way, you won't have to pay taxes on the money and neither will the new beneficiary so long as the money is used for qualified expenses.

Or you could always keep the money in its current 529 account in case your daughter decides that additional education or training is in her future. 529 assets may be used to cover graduate school or additional coursework.

Have a personal finance question you'd like answered? Send it to TheShortAnswer@morningstar.com.

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