How to Calculate 529 College Savings Plans Qualifying Distributions

Assuming that your designated beneficiary is a qualified student and is incurring qualified expenses, you now need to figure out just how much of a distribution you should make from your Section 529 plan. In calculating this number, here’s what you need to do:

  • Estimate how much the qualified expenses are likely to be, not only this year but also for the remainder of this student’s education. If you think that your savings may be a bit short, spending them all in one or two years may make sense. If you think that your student may qualify for need-based financial aid, spending the amount in the 529 plan in the first year or two may be to your advantage down the road.

  • Explore what other resources are available to make up any gaps in funding. If you don’t have the total cost of all qualified expenses sitting in your Section 529 plan, you’ll probably have to pay some portion of qualified expenses from your current earnings. If you also have a Coverdell Education Savings Account for your student, a portion of qualified expenses may be paid from there, as well.

  • Consider any outright grants and scholarships that your student may be entitled to. To the extent that any sort of scholarship, fellowship, or grant money is available, it always offsets qualified tuition expenses first. The income portion of any 529-distribution amounts that are not used to pay qualified educational expenses is generally treated as taxable income to the recipient.

  • If you want to take the Hope or Lifetime Learning Credit, you need to pay at least some qualified expenses using real, taxable income. This includes wages, taxable interest and dividends, rental income — you get the picture. You have to admit that this idea makes sense; you really shouldn’t get a tax credit for expenses that you paid with tax-exempt income.

Depending on the state and the type of 529 college savings plan you own, distributions are made directly from the plan to the school or to you or your designated beneficiary. The beneficiary bears the income tax consequences of distributions made to him or her.

If you’ve taken too large a distribution from your Section 529 plan, the world as you know it doesn’t really end. To the extent that the distribution exceeds the amount of qualified education expenses, the income portion on the overage will be taxed at the designated beneficiary’s tax rate, which is usually lower than your own.

In addition, unless the excess distribution amount is one of the qualified exceptions, the student will also pay an additional 10 percent penalty on the income portion only of the nonqualified amount.

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