529 Plans How You Can and Cant Use Them

If you are a parent who is concerned about the cost of higher education, you have every reason to be. This year's high school graduates could take on $37,300 in student loan debt in pursuit of a bachelor's degree. That doesn’t even take into consideration the costs of a graduate degree. What a huge burden to start your adult life with, right? It’s much better to start off at zero than in a deficit.

I know something about this since I incurred a great deal of student loan debt myself and it’s now a passion of mine to educate others about the best ways to approach education funding and planning. In fact, my two most recent blog posts focused on this topic: Financial Aid 101: What Families Need to Know Before They Apply and Four Things I Wish I Knew Before Applying to College.

In this new blog post, I focus on an important education savings tool: the 529 Plan, which is a tax-advantaged savings plan designed to encourage saving for future education costs.

What Are 529 Plans?

529 plans, legally known as “qualified tuition plans,” are sponsored by states, state agencies, or educational institutions and are authorized by Section 529 of the Internal Revenue Code. They are just one of several tools families can use to prepare for the growing costs of higher education.

There are two types of 529 plans: prepaid tuition plans and education savings plans.

The first, a prepaid tuition plan, allows you to lock in the cost of an in-state school. The idea is that you get tomorrow’s tuition at today’s prices. It’s important to remember that you’ll also need to save for room and board and other education expenses not covered in a prepaid tuition contract. In addition, with prepaid tuition plans, you may have to make up any difference in tuition prices if your child chooses to attend an out-of-state school.

The second type, 529 Education Savings Plans, are the more popular of the two. This type of account operates much like a Roth IRA. You invest with after-tax money and select how you want the funds invested. Some families choose “age-based” portfolios, which are invested based on the date your child will begin using the funds for higher education. The younger the child, the more aggressive the investment options may be. As your child gets closer to attending college, the money is gradually moved to more conservative investments.

All 50 states and the District of Columbia sponsor at least one type of 529 plan. In addition, a group of private colleges and universities sponsor a prepaid tuition plan. These plans can be beneficial for many since they let funds saved for education compound on a tax-free basis (federal tax and, in most cases, state and local taxes as well) as long as they're used for eligible education expenses. Many states offer tax deductions for residents who make contributions to a 529 plan.

Eligible Expenses Under a 529 Plan

Since 529 plans are state-sponsored programs – and each state has its own rules on what 529 funds can be used for – I have provided a fairly detailed list below of the most common expenses covered (all are for college expenses only). But make sure you check with your financial advisor or 529 plan if you’re unsure what qualifies.

  • Tuition and fees up to the full amount of college or vocational/trade school tuition and required fees and limited to $10K/year for K-12 expenses (not allowed in all states)
  • Books and supplies as long if they’re required to participate in a class
  • Computers, software and internet access if required to participate in a class
  • Meal plans
  • Room and board/off-campus housing as long as the student is enrolled at least half-time
  • Special needs equipment (families may want to consider using a 529 ABLE account to pay for qualified disability expenses beyond education expenses)
  • Student loan payments with a lifetime limit of $10,000 (not allowed in all states) and the caveat that not all states consider this a qualified education expense

Ineligible Expenses Under a 529 Plan

The items in the list below are considered non-qualified expenses and will incur income taxes on the earnings portion of withdrawals made to pay these expenses. Additionally, a 10% penalty will be imposed on the earnings. Some states may also impose additional penalties, so be sure to check with your state of residence.

  • Transportation and travel costs, including gas or transit passes
  • Sports or Activities
  • Health insurance, even if the college offers its own health insurance
  • Any costs incurred before the student is admitted to college are not considered qualified expenses. These include, but are not limited to, college application and testing fees as well as college counselor or admissions consultant fees

When Should I Take Withdrawals from My 529 Account?

Typically, withdrawals must be made during the same tax year that the qualified expenses are incurred. If you accidentally withdraw funds from the 529 in the wrong tax year, you can roll the funds back into the same or another 529 plan within 60 days to avoid taxes and penalties.

What Happens if My Student Receives a Scholarship?

Did you know that scholarships can be taxable? For example. scholarship funds used to pay for tuition and textbooks may be tax-free but when used to pay for living expenses is taxable. If a student receives a scholarship, that typically reduces the amount you should need to withdraw from your 529 account for the cost of attendance. However, you may take a non-qualified withdrawal up to the amount of the tax-free scholarship and avoid the 10% penalty. Yet, the earnings portion of that non-qualified withdrawal will still be subject to income taxes.

If I can help you as you consider a 529 Plan, or any other college planning questions, please contact me at Martial@MillstoneEvansGroup.com. I’d be pleased to explore the best options with you.

On a semi-regular basis, I’ll be sharing more blog posts on education savings plans and how families can evaluate options and plan ahead for tuition costs.