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Match Section 529 withdrawals to qualified expenses

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in Small Business Tax,Small Business Tax Deduction Strategies

Have you been setting aside funds in a Section 529 plan for your child’s college education? If your child has entered school, you can withdraw the funds tax-free to pay for qualified expenses. But you may be inclined to keep the account intact for a while longer so you can build up even more savings.

Strategy: Don’t do it. If your withdrawals for the current year don’t match your qualified expenses for that year, you could land in hot water with the IRS. It may treat future distributions as being paid for nonqualified expenses.

If that happens, you’ll be hit with ordinary income tax on the amount attributable to earnings, plus a 10% penalty tax on the earnings.

Here’s the whole story: A Section 529 plan is a savings program operated by a state (or associated agency) or one or more educational institutions. There are two primary types of 529 plans: the college savings plan and the prepaid tuition plan.

Generally, you don’t have to pay any tax on your contributions to the plan, the earnings within the plan and any distributions used to pay for qualified expenses (see box below). If the child completes school or decides not to attend college or leaves early, you can roll over the assets tax-free to a different beneficiary such as a younger child.

There’s no express requirement in the tax law that you must take withdrawals at the time when you incur qualified expenses. However, the IRS generally considers individual taxpayers to be governed by the cash-basis accounting rules, as opposed to accrual-basis accounting. Therefore, you normally are required to withdraw funds from a Section 529 plan in the same tax year in which you pay qualified expenses if you want tax-free treatment for the withdrawals.

Example: Let’s say your child started his or her senior year this fall. You have $25,000 left in the child’s Section 529 account composed of $10,000 in contributions and $15,000 in earnings. Although you’ll be paying for the child’s second semester in December 2009, you don’t plan on tapping the Section 529 plan until next year.

When you take the 529 distribution in 2010, you will receive a 2010 Form 1009-Q indicating the amount received in that year. If you’re audited, the IRS may compare this figure to the expenses you paid in 2010. Because there’s no match, you will be taxed on the earnings, plus you’ll have to pay a 10% penalty. In the 35% bracket, the little mistake will cost you a whopping $6,750 (35% of $15,000 plus $1,500).

Of course, if you have another child starting school in September 2010, you could avoid this dire tax result by designating the younger child as the beneficiary of the account.

Tip: The IRS recently proposed giving taxpayers a short “grace period” for withdrawals after the end of the tax year. But this change has not yet been approved.

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