Too much money in ESA and 529??

Paying for College
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<p>I hate to muddy the forum with yet another question about scholarships/1098/taxes but here goes.
We are in the enviable position that our D receives scholarships well beyond her cost of attendance. Her school produces accurate 1098s and figuring her taxable portion of this is not a problem.
We saved early and diligently and there is a large chunk of money in an ESA and a 529. It seemed at one point that this might come in handy for future med school tuition but that not a likely possibility now. She's done well in courses/required sciences etc but is just not interested in going that route. Graduate school still likely but not nearly as expensive (I'm thinking) as med school tuition.
So, any way, I was reading a thread about study abroad expenses and AOC and this tripped some ideas for me.
IN figuring "tax free scholarship" amount for her tax return, qualified expenses do not include room and board. Check.
In figuring "tax free distributions" from ESA and 529's, qualified expenses also include room and board. Check.
So, would it be doable to to take a distribution for room and board from either the ESA or the 529? I understand that the distribution is prorated between principal and earnings but, as I understand it, none is taxable if less than qualified expenses. Are you seeing my idea here? To figure taxability for ESA/529 distributions, qualified expense total is adjusted by "tax free" scholarship (the figure in her 1098 for tuition and fees) but not by that chunk of excess scholarship that she is taxed on. So......can we take a tax free distribution from ESA or 529 for the room and board expenses? What I'm saying is, she does get scholarship money greater than COA but not all of that is considered tax free.
This is just a thought. If it is possible to take a tax free distrib for room and board, I might consider doing it to pull $10,000 or so a year out tax free to, basically, use for incidental costs.
She's already a sophomore so this would probably only be for her last 2 years.
She is our only child and I know there are other options for money left in an account after college. Since it doesn't look like med school tuition is in her future, we had figured we would probably just assign any remaining money to her. She would be taxed on the earnings but I think would not owe the 10% penalty since excess is secondary to scholarships. The deadline to use the money is age 30, so maybe by then she'll have her own children and the beneficiary could be changed to them.
At any rate, I was wondering what any of you well versed financial posters (MomCat2, Entomom, et al) think of this possibility. We are not eligible for any other educational deductions or credits. It might be helpful to have a little tax free money from the stash we've saved but, happily, don't need to use for her undergraduate expenses.</p>

<p>What do you think?</p>

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<p>cbw -
Qualified expenses for 529 withdrawals = A)tuition/fees, B)required books/materials/supplies, and C)room & board</p>

<p>When you say that your daughter receives “scholarships well beyond her cost of attendance” do you mean that her scholarship is more than A + B + C ? - in other words neither your D or her parents needed to pay anything out of pocket OR from loans for any of those expenses? If so, wow - you’re a lucky family!</p>

<p>Hmm - you may have discovered an interesting loophole in that the regulations do say to only subtract out <em>Tax-free</em> scholarships when figuring the amount of qualified educational expenses for ESA/529 withdrawals. It’s a weird scenario (and one I’ve not dealt with, since our kids don’t get THAT much scholarship), but you might well be right that withdrawals up to amount of the <em>taxable</em> part of the scholarship would be tax-free. Hmmm - very interesting! </p>

<p>After that, you do know that you can take a withdrawal up to the amount of tax-free scholarship and have it be exempt from the 10% penalty? It sounds like you’re also aware that only the EARNINGS portion of that withdrawal would be taxable, and that it goes on your CHILD’S return, not yours, so is taxed at a lower rate (unless of course your kid is one of those young entrepreneurial geniuses or has lots of investment income or something!).
After THAT, additional withdrawal would be subject to tax (at her rate) + 10% penalty.</p>

<p>I may be wrong, but I’ve been under the impression that using the scholarship “exemption” from the tax-penalty thing is something that you use for years when your kid is still in school and therefore actively incurring those “qualified educational expenses”. I don’t think (but again, not certain) that you can wait and do it after she graduates - at that point I assume you would have to pay tax plus the penalty.</p>

<p>(I’m familiar w/ 529s, but not ESAs - just quickly skimming through Pub. 970, it looks like they’re quite similar, but I certainly don’t know all the detailed ins-and-outs!)</p>

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<p>MomCat2, yes we are very fortunate to be on the true free ride for undergrad expenses and her school actually allows her to stack her outside scholarships in addition to the univ funds and refunds all excess money to her (direct deposit, no less!!). This is all fabulous but it also means we are not using any of our hard saved cash inside her ESA and 529 plan.
I have never really considered it before tonight but I really think the theory I explained above is viable. It does feel like I have stumbled on a “loophole” to pull out some of that savings tax free.
But, I’m not sure and that’s why I’m looking for our savvy CC folks to check it out. Has anyone else done this? Do you interpret the use of the different definitions of “qualified expenses” (one set for figuring “taxable” scholarships and the other for figuring withdrawals from an ESA/529) as I do? Or am I really missing something and/or being delusional?
As I said, we are thrilled that our kid is loving undergrad and it’s costing us very little. She actually gets enough to cover most “personal expenses” but it’s hard to decline contributing to her budget or for specific personal items since, as she does point out, she is going to college for free.
At any rate, the whole light bulb going off thing tonight felt pretty good even if we never utilize it. It just felt good to be able to look at all those arcane rules and see a way to use them to our advantage.
Regarding the 10% penalty if you use the money for non-educational expenses, I looked again and I think the penalty is not accessed if the money withdrawn is less than any scholarship money received and that it can be done at any time, even after education expenses are done.
So, I’ve used up all my creative, money wrangling thoughts for the night. I am in tax mode right now as I am the designated, 3 generation tax prep woman (my daughter, my husband and I and my 85 year old mother).
That’s why I’m looking for objective feedback from my fellow CC’ers as I could just be overloaded on IRS speak at this point. I’ve learned in the past that our financial advisors really have no clue about handling educational expenses and I have more faith in my own reasoned interpretation of various IRS pubs. But I’ve followed various explanations here on CC for years and that has helped me figure it all out.
So, I’ll ponder this new insight and see if it still looks like a plausible loophole tomorrow.</p>

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<p>-
Yes, there definitely ARE different definitions of “qualified educational expenses” depending on which program or tax benefit you’re dealing with:

  1. for 529s (& I think ESAs, but you’d need to double check): Qualified expenses for 529 withdrawals = A)tuition/fees, B)required books/materials/supplies, and C)room & board</p>

<p>2)For the AOC and for the definition of NON-taxable scholarships/grants, qualified expenses = A + B</p>

<p>3) for the Lifetime Learning Credit, (IIRC - double-check me on this to be sure, readers), qualified educational expenses = A only</p>

<p>IIRC, in Pub. 970 there is a nice little chart which details all of this, and includes other education tax benefits. It also gives the income levels for eligibility for the different tax benefits -some phase out at different income levels.</p>

<p>I really don’t think that you can do penalty-free or tax-free withdrawals from 529s after your kid is finished with school. I’m too tired to pore over Pub. 970 for details right now, but I’m pretty sure that 529 withdrawals must be made in the same calendar year in which the qualified educational expenses are PAID (or in the case of using the scholarship exception to avoid the 10% tax penalty, I think this would be the year in which the scholarships funds “paid” for the expenses, i.e. when they were credited to the student’s account.) Once you’re past a year in which educational expenses were originally paid, then I think that the earnings on all withdrawals (remember, this is the ONLY portion which is taxed) would be subject to tax on the student’s return plus a 10% tax penalty.</p>

<p>I do know for sure that 529 funds can’t be used (without tax) to pay off a student loan after the student has graduated. I’m pretty sure that Joe Hurley discusses this on his financial aid site. Also, there are discussions on his site and others about how 529 withdrawals must be coordinated to correspond with the year in which expenses are PAID. </p>

<p>You are right that “regarding the 10% penalty if you use the money for non-educational expenses, I looked again and I think the penalty is not assessed if the money withdrawn is less than any scholarship money received”.</p>

<p>" I’ve learned in the past that our financial advisors really have no clue about handling educational expenses and I have more faith in my own reasoned interpretation of various IRS pubs." – man, you’ve got that right. It sounds like a lot of the tax software is pretty worthless in this area as well.</p>

<p>And it must be repeated (from other threads I’ve been on) - the 1098T is pretty worthless. You <em>always</em> need to refer to your OWN records of what you paid and when, and what the school’s charges were for tuition, R&B and various fees, etc.</p>