A 529 college savings plan offers many parents and future college students with an attractive option for socking away funds for tuition expenses. While the plan offers many benefits, the account holders don’t always understand the mechanics of how the plans work and how they can be used effectively. Find out if you understand the complete capabilities and limitations of these plans.

What’s a 529 college savings plan?
Contributions to these state sponsored educational savings plans grow tax-deferred, and distributions to pay for the beneficiary’s college costs are tax-free. Expenses for the plan can be used for tuition, fees, books, supplies, and equipment. Room and board are also covered by the plan as long as the beneficiary is a student for at least half of the school year.

What if I withdraw the funds and pay the tuition the next year?
The 529 plan is part of the Internal Revenue Code. As such, the timing for withdrawing funds from the account and using them to pay for tuition must occur in the same tax year. This means that if you withdraw funds from a 529 plan at the end of 2013, they must be used to pay 2013 tuition bills. Otherwise, you may have to pay taxes on what was supposed to be tax-free earnings.

Claiming the state tax deduction properly
Most states also offer a state tax deduction for contributing to the plan. For instance, a married couple filing jointly with a New York State sponsored plan, could deduct up to $10,000 of their contribution; married filing separate filers would be able to deduct up to $5,000 per year. Please note that in most states like New York, the 529 plan account holder is only allowed one deduction per year even if they own another 529 plan account. In addition, if a grandparent or third party wants to contribute to a 529 plan and claim the state tax deduction, they would have to open a separate 529 plan account from the parent.

Take into account scholarships and educational tax credits
You need to plan ahead when considering how much money you should withdraw from the 529 plan when it’s time to pay for tuition. If you withdraw enough to cover all of tuition for the year and later find out that the student qualifies for a partial scholarship and/or an educational tax credit, you may not be able to use all of the 529 plan distribution tax-free. You cannot combine 529 plan distributions to cover the same expenses that are covered by a scholarship or tax credit.

If you do happen to withdraw too much from the 529 plan, you could always rollover the excess amount into another 529 account within 60 days. Please note that you’re only allowed only one rollover for each 529 account you own within any 12 month period.

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