I plan to pay my son's tuition fees without taking any distributions. I may start withdrawing a year or two from now. Will this create a problem with taxes (filing complication, fines or additional taxes)? I live in California (Scholarshare) and the fees are for an undergraduate degree at an accredited 4-year college.
For it to be a qualified distribution, you must actually have paid qualified educational expenses in the year you take a distribution from your 529 plan. So, for example, you cannot wait until 2020 to take out money to reimburse yourself for expenses you paid in 2019.
529 distributions have to be made the same year the tuition is DUE. In other words you can get a bill in Dec for Jan tuition, room & board. You will want to keep things simple and take out $ in Jan.
In my opinion I would take the funds out of the 529 whenever you are allowed to do it. Balance it with the American Opportunity credit, you want to use that the first 4 years of college if you can. There are income limits however.
Having $ leftover in the 529 after college is completed is not a benefit. Grad school might be paid by employer.
"529 distributions have to be made the same year the tuition is DUE."
That is not correct. To be eligible for favorable tax treatment, 529 distributions have to be made the same year that qualified expenses (tuition, fees, course materials, room & board) are PAID.
For more on balancing 529 distributions with the American Opportunity Credit, see below.
For 529 plans, there is an “owner” (usually the parent), and a “beneficiary” (usually the student dependent). The "recipient" of the distribution can be either the owner or the beneficiary depending on who the money was sent to. When the money goes directly from the Qualified Tuition Plan (QTP) to the school, the student is the "recipient". The distribution will be reported on IRS form 1099-Q.
The 1099-Q gets reported on the recipient's return.** The recipient's name & SS# will be on the 1099-Q.
Even though the 1099-Q is going on the student's return, the 1098-T should go on the parent's return, so you can claim the education credit. You can do this because he is your dependent.
You can and should claim the tuition credit before claiming the 529 plan earnings exclusion. The educational expenses he claims for the 1099-Q should be reduced by the amount of educational expenses you claim for the credit.
But be aware, you can not double dip. You cannot count the same tuition money, for the tuition credit, that gets him an exclusion from the taxability of the earnings (interest) on the 529 plan. Since the credit is more generous; use as much of the tuition as is needed for the credit and the rest for the interest exclusion. Another special rule allows you to claim the tuition credit even though it was "his" money that paid the tuition.
In addition, there is another rule that says the 10% penalty is waived if he was unable to cover the 529 plan withdrawal with educational expenses either because he got scholarships or the expenses were used (by him or the parents) to claim the credits. He'll have to pay tax on the earnings, at his lower tax rate (subject to the “kiddie tax”), but not the penalty.
Total qualified expenses (including room & board) less amounts paid by scholarship less amounts used to claim the Tuition credit equals the amount you can use to claim the earnings exclusion on the 1099-Q.
$10,000 in educational expenses(including room & board)
-$3000 paid by tax free scholarship
-$4000 used to claim the American Opportunity credit
=$3000 Can be used against the 1099-Q (usually on the student’s return)
Box 1 of the 1099-Q is $5000
Box 2 is $600
3000/5000=60% of the earnings are tax free
You have $240 of taxable income (600-360)
**Alternatively; you can just not report the 1099-Q, at all, if your student-beneficiary has sufficient educational expenses, including room & board (even if he lives at home) to cover the distribution. You would still have to do the math to see if there were enough expenses left over for you to claim the tuition credit. Again, you cannot double dip! When the box 1 amount on form 1099-Q is fully covered by expenses, TurboTax will enter nothing about the 1099-Q on the actual tax forms. But, it will prepare a 1099-Q worksheet for your records, in case of an IRS inquiry.