Tax-favored Section 529 college savings plans (sometimes called qualified tuition programs) have been around long enough that many people are now taking withdrawals. Qualified withdrawals are always federal-income-tax-free (and usually state-income-tax-free too). That s the big advantage of investing in 529 plans. However, the full story on withdrawals is pretty complicated. Here are four important things you should know.

1. You have two payment options

You can have the withdrawal check cut in the name of the account beneficiary (the student for whom the account was set up, which is usually your child or grandchild).

Alternatively, you can have the check cut in your name as the account owner or plan participant (both terms are used to describe the person who established and funded the account).

If the money from the withdrawal will go to the account beneficiary, I recommend having the check made out to him or her. If you re keeping the withdrawal for yourself, have the check made out to you. Following this advice will make it easier for the tax consequences explained later to follow the money.

It s important to understand that you re not permitted to keep a withdrawal from a 529 account that was funded with money from a custodial account set up for your child or grandchild. Any money taken from the 529 account must be used to benefit the kid.

On the other hand, if you funded the 529 account with your own money, the withdrawal belongs to you and you can do whatever you want with it. That said, beware of the tax implications explained later.

2. The IRS knows what happened

For any year when a 529 withdrawal is taken, the plan must issue a Form 1099-Q (Payments From Qualified Education Programs) by Feb. 1 of the following year. If the withdrawal check is made out to the account beneficiary, the 1099-Q comes to that person. If the check is made out to you as the account owner, the 1099-Q comes to you. Either way, the IRS gets a copy. So the feds know what happened.

Line 1 of the 1099-Q shows the total amount withdrawn during the year. Assuming the account made money, any withdrawal will include some earnings and some basis from contributions. Withdrawn earnings are shown on line 2 of the 1099-Q. They may or may not be tax free. Withdrawn basis amounts are shown on line 3. They are always tax free.

3. Withdrawals are not necessarily tax free, even in years with heavy college costs

When the 1099-Q shows withdrawn earnings, the IRS might become interested in the recipient s Form 1040, because some or all of the earnings might be taxable. Here s the deal on that.

Withdrawn earnings are always tax free when total withdrawals for the year don t exceed the account beneficiary s adjusted qualified education expenses. Adjusted education expenses equal tuition and related fees, plus room and board (but only if the student carries at least half of a full-time load), plus books and supplies, plus computer and Internet access costs; minus costs covered by Pell grants; minus costs covered by tax-free scholarships, fellowships, and tuition discounts; minus any costs used to claim the American Opportunity or Lifetime Learning tax credit; and minus any costs used to claim the deduction for tuition and fees.

When withdrawals exceed adjusted qualified education expenses, all or part of the withdrawn earnings will be taxable. This little-known truth may be an unpleasant surprise.

Example : Say your daughter has $36,000 of college expenses. She receives $24,000 in tax-free scholarships and tuition discounts, so her adjusted education expenses are only $12,000. You take a $36,000 withdrawal from her 529 account, which includes $6,000 in earnings. You use the money to cover the $12,000 of adjusted education expenses; plus transportation expenses, pizza and other incidentals; plus a car for the kid because you re ecstatic about all the free money she got. Because the $12,000 of adjusted education expenses is only one-third of the 529 withdrawal, only one-third of the withdrawn earnings, or $2,000, is tax free. The remaining $4,000 is taxable and should be reported on line 21 of your daughter s Form 1040. Depending on her overall tax situation and whether the Kiddie Tax applies, the tax hit on the $4,000 may or may not be significant.

Advice : In this scenario, have the withdrawal check made out in your child s name. Then have it signed over to you so you can control the spending. That way, your child will get the 1099-Q, which keeps things straight because he or she will bear the tax consequences.

4. You can keep withdrawals for yourself (usually)

If the 529 account was funded with your own money, you re free to change the account beneficiary to yourself and take tax-free withdrawals to cover your own qualified education expenses if you decide to go back to school. Earnings included in withdrawals used for other purposes will be taxable (report them on line 21 of your Form 1040) and will probably be hit with a 10% penalty to boot (see IRS Form 5329). Finally, if you liquidate a loser 529 account (worth less than you contributed), you won t owe anything to the IRS, and you might even be able to claim a tax-saving write-off.