16 March 2016
I am big fan of the Virginia 529 program. It offers a lot of flexibility and a variety of opportunities to get tax breaks to save for higher education. Unfortunately, it also offers a lot of opportunities to screw up when you are taking the money out to spend on college. If not done properly you could find yourself paying both taxes and tax penalties on money that should have been (and was planned to be) tax free.
The biggest penalties may not come from the IRS, either. If you took a Virginia state tax deduction for your past contributions, you have to pay Virginia back the amount of tax you originally saved plus interest. You might have made that contribution 15 or more years in the past. That could add up to a lot of interest. The normal six-year statute of limitations on Virginia back taxes does not apply, either. It doesn't matter when the contributions were made, if you don't use that money for higher education (or have a qualifying exemption) you have to pay Richmond back. That could be very very painful.
This article is going to walk you through some of the things that can go wrong and what you can do to fix them if they happen. It's a little embarrassing to admit, being a knowledgeable tax professional and all, but I have been guilty of several of the examples below. So when I say it's easy to screw up the spending part of the Virginia 529 plan, I speak from experience. (What was even worse was that when I called the Virginia 529 help line they told me to speak with my tax professional. D'Oh!)
Problem - You took money out of your Virginia 529 in December for tuition you paid in January. Seems harmless enough, but that’s two different tax years. Money withdrawn in 2015 needs to get matched against qualifying expenses paid in 2015. If you can’t match up your tax qualified money against qualifying expenses on your tax return you may be in line for some taxes and penalties.
Solution – Put it into a different 529 account. If you put the money back into another 529 account within 60 days of withdrawing it then it counts as a rollover and you are not taxed. You can put it back in an account with the same beneficiary only once per year. You could also put it in another beneficiary’s account (i.e. a sibling) as long as the new beneficiary is a family member. You could even open an account for yourself and stick it in there. In a future year you can always withdraw it again and put it back in the original account. Just remember that you cannot take another tax deduction for the money if you are rolling it over. The Virginia state tax deduction only counts toward original contributions.
Problem – You paid tuition with money you withdrew from your Virginia 529 account and now you don’t have enough qualifying expenses left to claim the American Opportunity Credit. This mistake is easy to make because you might be paying the tuition in January and you won’t be filing for the American Opportunity Credit on your tax return until March or April of the next year. You’re probably not thinking about your taxes 15 months out when you’re paying the tuition. While there are several different higher education tax benefits, the IRS generally allows us to take only one tax benefit on each dollar spent on higher education.
Solution 1 – Dig for additional college-related expenses. It would be pretty rare for the tax-free character of the Virginia 529 withdrawal to be more valuable than the very generous American Opportunity Credit (AOC), so you will want to be able to claim the AOC. The list of qualifying expenses for AOC is much more limited than it is for the 529 money, so apply up to $4,000 (the max) of expenses that qualify for AOC against the AOC, and then look for additional expenses to match up to the 529 money. Room and board, parking passes, and computers are some of the expenses that qualify under Virginia 529 plan.
Solution 2 – Pay the tax on the Virginia 529 money. If you can’t come up with enough qualifying expenses to justify your Virginia 529 withdrawal, then you either have to not claim AOC or pay the tax on the Virginia 529 money. Given that situation your best choice is likely to pay the Virginia 529 tax. Fortunately, the IRS waives the penalty (not the tax, though) if your 529 money is disqualified because you took a different tax credit. Always run the numbers to be sure, but the AOC is so valuable you will nearly always come out ahead by claiming it and disqualifying all or part of your Virginia 529 withdrawal.
Problem – You didn’t take out enough money. Your child has graduated and everything is paid for, but there is still some money in the Virginia 529 account. I put this in the category of good problems to have, but it is still a problem. If you take that money out for anything other than qualified higher education expenses you are going to have to pay taxes and penalties.
Solution 1 – Leave it within the 529 system. There are multiple scenarios under this option.
a) If the original beneficiary has a sibling the money can be rolled over to the sibling’s account.
b) If you want to start saving for your grandchild(ren)’s college you can use this account even if the grandchild is not yet born. Simply leave the account with the originally named beneficiary until the grandchild is born and then change the beneficiary to the newborn. (Keep in mind that if there is substantial money involved you might run into transfer taxes – currently 40%. Come see me first if that is the case!)
c) You can open an account in another person’s name and move the money there.
Solution 2 – Withdraw the money as efficiently as possible. If you want to get the money out of the Virginia 529 program, but don’t have qualifying higher education expenses, at least try to be as tax efficient as possible with your withdrawals. Don’t withdraw so much in one year that it moves you to a higher tax bracket. You might also consider whether you or the beneficiary would pay more taxes on the distribution. Either of you can make the withdrawal and the tax is owed by the recipient. It might be more beneficial for your child to take the distribution and pay the taxes than it would be for you to do it.
The Virginia 529 plan is a fantastic program. It offers some great tax savings for parents in the accumulation phase of college planning for their children, with no income-based restrictions. But the rules are complex, and unsuspecting parents/taxpayers will sometimes unwittingly fall into a trap during the distribution phase of the college plan.
If you have questions about using your Virginia 529 plan as efficiently as possible, please contact me.