Qualified higher educational expenses
Beneficiaries are only able to make tax-free withdrawals from a 529 if they use the funds for “qualified education expenses.” So let’s define what that is.
What is a 529 plan qualified expense?
Qualified education expenses for the purpose of a 529 college savings plan include the expenses that are required to enroll in and attend an accredited private or public college or university.
As with financial aid, these expenses have to fall into the school-certified cost of attendance — the calculations a school does to determine the reasonable costs to live near and attend a particular campus.
- Required fees
- Required books
- School supplies
- Housing (on- or off-campus)
- A meal plan
The cost of housing is a qualified expense even if the student lives off campus, but it’s capped at the amount reported by the college in its annual cost of attendance.
Private K-12 expenses
In addition to college education, you can use a 529 plan to pay for elementary and secondary education expenses. The 529 savings plans were expanded as part of the Tax Cuts and Jobs Act of 2017 to cover tuition expenses of up to $10,000 per year for K-12 schools.
What is not a qualified education expense?
Funds from a 529 plan don’t cover things like health insurance premiums (even if they are paid to your school) or transportation expenses to, from, or around campus.
College application fees and testing fees are also not qualified expenses, even if you’re required to pay them to attend the school.
What happens when withdrawals aren’t used for qualified education expenses?
Beneficiaries are allowed to withdraw money from a 529 savings plan at any time for any reason. If they use the money for anything other than qualified education expenses, they’ll owe a 10% federal tax penalty plus federal income taxes on the plan’s earnings.
Here’s how that works: Say you’ve contributed $10,000 to your child’s 529 plan, and the account is worth $25,000 when they’re ready to attend college. If your child doesn’t go to college and you withdraw the $25,000 for another purpose, you’ll pay the 10% penalty on the plan’s earnings ($15,000), but not on your original $10,000 contribution. You’ll also need to claim the $15,000 as part of your taxable income for the year of the withdrawal.
The same applies for any partial withdrawals not used for qualified expenses. The withdrawal will be allocated proportionally among tax-free contributions and taxable earnings, and you’ll pay the penalty and taxes on the taxable portion.
In the example above, say you only withdraw $5,000. You’ll pay the penalty and taxes on an amount proportionate to the $15,000 earnings on your $25,000 balance. So $3,000 of the $5,000 is taxable. Of the $20,000 remaining in your account, $12,000 will still count as earnings.
If you end up saving more money in a 529 than the beneficiary needs to cover their education expenses, there are a few options. You can:
Designate a new beneficiary
You can change the designated beneficiary of a 529 plan to another family member whenever you want by rolling funds into a new account for the new beneficiary. Under the IRS definition, a “family member” must be the beneficiary’s:
- First cousin
- Parent’s sibling
- Sibling’s child
This is usually a quick and easy process. For example, if your oldest child ends up having leftover 529 funds, you could roll them into a 529 account for a younger sibling.
Similarly, you could hold on to the funds and roll them into an account for the beneficiary’s child. You’re not required to use them within any timeframe, so funds can roll over from generation to generation.
Save the funds for more education
The beneficiary could use the funds for education costs at any point. So you can keep the money in the account until you want to pull it out for undergrad education or graduate school down the line, no matter how many years pass.
Pay down student loan debt
Under the SECURE Act of 2019, the 529 plans were expanded to let you use up to $10,000 of the funds to repay private or federal student loan debt. That’s $10,000 each per beneficiary and their siblings.
Withdraw the money for non-qualified expenses
If you don’t have an education-related need for the funds, you can always withdraw them and pay the penalty. Just make sure you account for the penalty and taxes when considering how you’ll spend the money. You might not want to withdraw everything at once if it would mean a significant boost in taxes one year.
How to choose a 529 plan
Your home state’s plan is a good place to start your search for the right 529 plan. If you live in a state that has an income tax, there’s a good chance you’ll get a state tax break for your contributions. If your state doesn’t have an income tax, it could make more sense to shop around for a plan with the most appealing fee structure and investment options.
Similarly, be aware that several states have more than one 529 savings plan, and fees can vary a lot among them. For example, South Carolina has two — a 529 savings plan sold directly through the state, and another that is sold by financial advisors. The advisor-sold option is by far the more expensive, as is the case in several other states.
How to open a 529 plan
How you open a 529 plan varies depending on the state operating the plan and the private company managing it.
Many states have direct-sold 529 college savings plans, which you can enroll in directly by filling out a short application and providing some personal information about you and the beneficiary.
(Tip: Have the beneficiary’s Social Security number handy before applying.)
Many states also offer advisor-sold 529 plans, which can be helpful if you’re unsure about how to invest the money you contribute. Your state’s 529 website likely lists financial advisors who are licensed to sell these plans, and you can open one by contacting the advisor.
The state’s direct-sold version of a 529 plan will almost always have lower fees than the advisor-sold plans. Advisor-sold plans generally have higher investment fees, and the advisors who sell them may also get a sales commission upfront that eats 1% to 5% of your contributions. The downside to a direct-sold plan is that you’re pretty much on your own when it comes to investment strategies.
The bottom line is that there is value in speaking to a financial advisor who can help guide your college savings strategy. The question is how much of a premium you’ll have to pay for this advice, and whether the extra expense is worth it.
Other college savings accounts to consider
A 529 plan is not the only way you can save for college. Here are some alternatives:
The other major education-specific investment account is a Coverdell Education Savings Account, better known as a Coverdell ESA. These have the same federal tax treatment as 529 plans. However, unlike a 529 plan, these accounts aren’t state-run and can be opened with many major brokerage firms.
There are some advantages to using a Coverdell, particularly when it comes to investment flexibility. With a 529 plan, you’re generally limited to a couple dozen investment funds at best. With a Coverdell, you can invest in virtually any stocks, bonds, or mutual funds you want.
However, in most cases, the downsides to using a Coverdell outweigh the advantages. Most significantly, contributions are limited to just $2,000 per year per beneficiary. And there’s no possibility of a state tax deduction for contributing.
You could also save for college through a Roth IRA.
An Individual Retirement Account has the same basic tax treatment on contributions as 529 plans and Coverdell ESAs. Although they are designed for retirement, there’s an exception to the early withdrawal penalty for qualifying higher education expenses. If the beneficiary doesn’t end up going to college, you can simply use the money toward your own retirement. This is a great option for anyone who wants to save a college nest egg but isn’t sure whether the beneficiary will need it.
As college tuition gets more expensive, it makes sense to start saving early to help your loved ones pay for education. While a 529 savings plan can be a great way to save for college, it isn’t the only way. Weigh the pros and cons of all your options before deciding.
View more information: https://www.fool.com/the-ascent/buying-stocks/what-is-529-plan/