Then she switched planners and learned that wasn't the case—just in time, as her daughter is now a freshman at the University of Oklahoma. "You have to know what you can use the money for so you don't wind up paying more in taxes and penalties," says Ms. Craft, who lives near Dallas.
Her new financial planner, Todd Schneider of Southlake, Texas, says he has encountered a lot of confusion among clients about how to use the money they have accumulated in the plans—and has saved them from a number of tax traps. Still, he worries many people have committed fouls they might not discover unless they wind up getting audited.
The 529 plans are state-sponsored investment accounts whose earnings can be withdrawn free of taxes as long as they are used for qualified higher-education expenses. Many states also offer income-tax breaks on contributions.
For 2013, an estimated $19 billion went into 529 plans (before withdrawals), compared with $18 billion in 2012, according to Strategic Insight, a firm that tracks the plans. The accounts held $191.3 billion in assets as of Sept. 30, up 17% from a year earlier.
Here are some ways to avoid the plans' pitfalls.
Pay attention to timing.
The biggest mistake that Mr. Schneider sees people make is withdrawing 529 savings in one calendar year—and then waiting until the following year to pay the bill. Those are two different tax years, and the Internal Revenue Service hasn't issued a final rule on whether withdrawing money from a 529 account one year and using it the next is allowed or not.
The upshot: Money not used in the year it is withdrawn could wind up being subject to taxes and a 10% penalty.
It is an easy trap to fall into when paying bills for the spring semester, because families often will start the process during the holidays, get sidetracked, and then turn back to bill-paying after Jan. 1, Mr. Schneider says.
To avoid the problem, wait until after Jan. 1 to request the needed funds, he says.
The IRS has said it plans to propose a rule to allow 529 withdrawals to cover current-year expenses along with expenses in the first three months of the following year, says Joe Hurley, whose website, Savingforcollege.com, offers in-depth information about 529 plans. But so far, no changes have been made.
Make sure the expenses qualify.
Before you withdraw 529 savings to pay a college bill, double-check that you are allowed to do so.
Ms. Craft, in suburban Dallas, says she might have been tripped up by the limits on housing and food expenses when her daughter moves off campus next year had she not learned about the limits on the use of 529 withdrawals.
Qualified expenses have to be paid for the account's designated beneficiary. They include tuition, fees, books, supplies and equipment, and special-needs services incurred in connection with enrollment or attendance at an eligible school. Room-and-board expenses are allowed only for students enrolled at least halftime.
IRS Publication 970, "Tax Benefits for Education" (available at IRS.gov), lists expenses that qualify. Other sources of information include www.collegesavings.org andMorningstar.com (search for "529").
Take any scholarships or tax credits into account.
Here is a good problem, but a problem nonetheless: You withdraw enough from a 529 account to pay your child's tuition fully. Then it turns out you owe a smaller amount, due to a scholarship your child is awarded midyear.
Besides scholarships, the federal government offers a number of tax credits. The most valuable one for many taxpayers is the American Opportunity Tax Credit, worth up to $2,500 per student. The credit is generally available to individuals with a modified adjusted gross income of up to $90,000 a year or $180,000 for married couples filing a joint tax return, then phased out for those with higher incomes.
But getting that credit means that up to $4,000 would have to be subtracted from college expenses you could pay with 529 withdrawals. (You can take a $2,000 tax credit on the first $2,000 of qualified expenses and then take a 25% credit on the next $2,000.)
If you overlooked those expenses and already withdrew the money from a 529, you would owe income tax—but the 10% penalty would be waived, Mr. Schneider says.
Act fast on fixes.
If you do find that you have taken too much from the account, you could roll the excess amount into a different 529 account within 60 days. That way, the amount would no longer be treated as a distribution. One caveat: You're allowed only one rollover for each 529 account you own within any 12-month period.
You also could try to pay the following year's expenses, but educational institutions vary on whether they will take prepayments, Mr. Schneider says.
Check before you make a big gift.
Assets you contribute to a 529 account no longer count as part of your estate even if you are the account owner. That makes them especially appealing for many grandparents.
Another advantage: Each grandparent can contribute up to $14,000 a year in a 529 account for each child without incurring gift taxes or $70,000 in one fell swoop, using up five years of gifts at once.
Still, people who make five-year gifts have to file a federal gift-tax form to make sure they get the full exemptions, Mr. Schneider says.
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