Retirement & Financial Planning Report

Many people believe that distributions from 529 plans are tax-free if the money is spent on higher education. That may not be true, though.

Technically, tax-free withdrawals from 529 plans are limited to "adjusted" qualified higher education expenses. Those adjustments can include money from grants, scholarships, and other non-taxable payments received as educational assistance.

For example, suppose Alan Smith sends his son Tom to a college where the total costs are posted as $35,000 a year. Tom gets a $15,000 scholarship so Alan only pays $20,000 this year.

To pay that bill, Alan withdraws $20,000 from his 529 account to pay those costs. However, his adjusted qualified educational expenses are only $5,000: $20,000 in actual cost minus the $15,000 scholarship.

By withdrawing $20,000, Alan would be $15,000 over the limit. He will have to go through a complicated calculation to see what portion of the $15,000 overage is subject to income tax and a 10 percent penalty. Therefore, you should check with a tax pro before taking money from a 529 account.