529 Plan Boobytrap: Beware of Taxes

Last Updated Mar 12, 2010 1:22 AM EST

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Many parents love 529 plans because they can withdraw their college cash from these accounts without triggering taxes.

This tax-free promise, however, isn't airtight. Families will owe taxes if the 529 money they withdraw exceeds their "qualified" college expenses. These costs include tuition, fees, books and supplies, as well as room and board for students attending college at least half time.

If your 529 withdrawals exceed your costs, you would face taxes on the excess distribution and a 10% withdrawal penalty.

You might be thinking that it should be easy to avoid overdrawing your 529 college account, but think again. A double-dipping rule could trip you up.

Here's the problem: The government will punish you if you try to claim the American Opportunity, Hope or Lifetime Learning education tax credits for the same expenses that you pay with the cash from your 529 plan or Coverdell Education Savings Account.

Why the double-dipping rule? You are already enjoying a tax benefit via Uncle Sam when you pull tax-free money out of a 529 or Coverdell. The government doesn't want you to get yet another tax freebie for the same cash.

Before you try pulling money out of a 529 plan or Coverdell, consult your accountant or IRS Publication 970: Tax Benefits for Education.
Lynn O'Shaughnessy is the author of The College Solution and she also writes about college for TheCollegeSolutionBlog. Follow her on Twitter.

529 College Savings Plan image by alancleaver. CC 2.0.

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