June 2, 2019

529 Qualified Expenses

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Whether you are saving to fund future college education expenses or participating in prepaid tuition to fund a beneficiary's education expenses, enrollment in a 529 plan is a powerful, tax-advantaged tool.

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529 plans, also known legally as qualified tuition programs, are college savings accounts designed to help individuals save on behalf of a designated beneficiary. This beneficiary can be your child or other family member, a friend, or even yourself.

The plans include perks like tax-deferred growth and tax-free withdrawals for qualified education expenses. But just what are these qualified education expenses?

Keep reading to learn more.

Qualified Expenses for a 529 Plan

Qualified expenses differ based on the two types of 529 plans: prepaid tuition plans and savings plans.

We discuss 529 prepaid tuition plans for private elementary and high school below. For now, let's focus on qualified expenses for eligible higher education institutions, including

  • Colleges and Universities
  • Vocational School and Post-Secondary Institutions
  • Most Accredited Public and Nonprofit Schools
  • Privately Owned and Profit-Making Post-Secondary Institutions

The Department of Education determines institution eligibility. Search here to see if your school of choice is eligible. A small number of eligible institutions are not on this list, so you may need to ask your school.

States also have their own unique plans in place. They are permitted to offer both types of 529 plans.

Prepaid Tuition Plan Qualified Expenses
This plan lets you prepay one or more semesters for qualifying colleges or universities at today's cost. (Usually, the cost is calculated by credits or units.) This ensures you pay tuition at a set price, shielding you and your beneficiary from inflation.

Qualified expenses include:

Tuition pre-payments at an eligible educational institution for both full-time and part-time students for one semester or more.

Room and Board is RARELY considered a qualifying expense under this plan. However, in some situations where room and board is paid DIRECTLY to the college or university, it does qualify under unique and diverse plans.

Check with your plan administrator to see if your situation qualifies.

College Savings Plan Qualified Expenses
Under this plan, your contributions to a college savings plan are invested in mutual funds, stock mutual funds, or money market funds according to the SEC (U.S. Securities and Exchange Commission).

Your contributions and earnings can be used for a wide range of qualified education expenses compared to 529 prepaid tuition plans.

Qualified expenses include:

  • Tuition: At an eligible educational institution for both full-time and part-time students. This also includes some eligible technical colleges, as well as some foreign school programs.

  • Room and Board: Paid directly to the college or university if the student is attending half-time or more.*

    *This includes no greater than the allowance for room and board included in the school's cost of attendance for federal financial aid calculations OR the actual amount charged if the student is living in housing operated by the educational institution.

    If the student plans to live off-campus and the rent is greater than the school's estimates for room and board while in attendance, the excess amount is NOT considered a qualified expense.

  • Mandatory Fees: Charged by the eligible educational institution in relation to tuition or room and board.

  • Books and Supplies: ONLY if they are required by the school for a course.

  • Technology Needs: Such as computers and related equipment (printers and modems) and services (internet) are qualified expenses if used primarily by the beneficiary during the years that the student is enrolled at an eligible education institution.

    Computer software is considered a qualified expense if it is educational in nature and is a requirement for a course.

529 plans cover many qualified education expenses. Read on to find out what they don't cover.

Expenses that Do Not Qualify for a 529 Plan

Here are expenses that do not qualify under either the 529 Prepaid Tuition plan or 529 College Savings plans:

  • Insurance: Even if paid to the school. You WILL pay a penalty if you use your 529 plan money for insurance.

  • Sports/Health Club Expenses: Unless required for a course.

  • Smartphones: Unless a course requires you to buy one.

  • Travel Costs: Only considered qualified education expenses if you are required to travel as part of a course.

  • Repayment of Student Loans: Are also not a qualified expense.

  • Off-Campus Housing Expeneses that Exceed School's: If the school offers on-campus housing for $9,000 for the school year, and your off-campus housing costs you $10,000, the excess amount ($1,000) is NOT considered a qualified education expense.

Other than qualified education expenses, what are the advantages of a 529 plan? Read on.

529 Plan Advantages

Tax advantages are a prime benefit for 529 plans. But here are some other benefits:

  • Earnings: Grow tax-exempt. There are no penalties attached to money that grows while in a 529 plan.

  • Withdrawals: Are non-taxable and penalty-free if they are made for qualified higher education expenses.

  • Anyone can Enroll: They contribute to a 529 plan on behalf of a designated beneficiary. Relatives, family, and friends—even the beneficiary—can establish a 529 plan.

  • Beneficiaries Can Be Changed: Without incurring tax consequences in most situations. This is a great option if your child receives a scholarship or grant, or if they decide to not attend college at all. The student or beneficiary can even be changed to you if you have plans to attend an eligible school.

    Any change of beneficiary to a non-eligible family member of the current beneficiary is considered a non-qualified withdrawal. That withdrawal will be subject to federal and state income tax, as well as 10% federal tax penalty.

  • Roll Over Funds: You can roll over funds from one 529 account to another 529 plan for one of your children without penalty. This is a fantastic option if you have money left over in a plan from one child and need additional money for another.

  • Less Need for Student Loans: One of the main advantages of opening a 529 plan.

  • Automatic Investment Payments: You can begin a plan for $15 per month or $45 quarterly.

    The initial contribution minimum averages $250 per plan. You can pay as much as you want throughout the year until the maximum contribution has been reached.

    Federal law currently allows single taxpayers to contribute up to $15,000 in one year, and state plans vary.

  • Ease of Management: The 529 plan invests money for you. Investments are automatically adjusted based on anticipated need dates.

    Example: As your child nears college age, the funds are moved to less risky investments.

  • Low Fees: Compared to other types of college savings plans. Fees are assessed based on program management expenses. They are not charged out-of-pocket. Administrative fees for the average 529 plan can be as low as 0.28%.

  • Federally Insured in Most States: Compared to other college savings plans which can be riskier and have less coverage.

  • No Limits: There are no limits on the number of 529 plans that you can set up.

  • State Income Tax Can be Reduced: Tax can be reduced by contribution amounts. Some states allow you to carry excess contributions over from year to year. However, state-by-state restrictions do apply.

529 plan state tax benefits vary state-to-state.
In these 529 Deduction or Credit examples, the filing status is married and filing jointly. Single filers typically may claim half of the amount:

  • Alabama allows $10,000 annually
  • Indiana allows a 20% tax credit on contributions up to $5,000
  • New Mexico allows the entire contribution amount

Check with the school your beneficiary will attend for state benefits and requirements. For example, some may require residency.

Foreign schools are also eligible for 529 plans, but restrictions apply.

Read on to learn the disadvantages BEFORE choosing a 529 plan.

529 Plan Disadvantages

  • State Residency Restrictions: These often apply to 529 prepaid tuition plans. Other college savings plans usually have no residency requirements. Check with your school for information.

  • Limited Enrollment Periods: can apply to 529 prepaid tuition plans state by state.

  • Savings and Earnings are limited by the student's enrollment date. If the 529 plan is started close to the date the student will enter college, the earnings will be less and may not exist at all. This may greatly increase the need for other financial aid including student loans.

  • Counts Against Eligibility for Financial Aid: Reduces the eligible amount of student loans and other types of financial aid.

  • Tax and penalty-free withdrawals are limited to qualified expenses compared to a personal savings plan set aside for college.

    Another investment consideration is a Roth IRA, which has similar tax advantages but no penalty for withdrawing higher education expenses. Plus, if you don't use the Roth IRA investments entirely for school, you can continue to build for retirement.

The 10% federal penalty may be waived under certain circumstances for 529 withdrawals, such as:
  • Disability or death of the beneficiary
  • The receipt of a scholarship
  • Veteran's education expense
  • Other non-taxable gift or inheritance

How can you take money from a 529 Plan? Keep reading to find out.

How to Withdraw 529 Plan Funds

Withdrawals from 529 plans are tax-free IF the funds are used for qualified higher education expenses at an eligible institution.

Most plans allow you to write a check directly from the plan, while some allow EFT transfers. Keep in mind, though, that checks are a much slower process than an EFT transfer, especially if that check is mailed.

Here are some other ways:

Pay Yourself
By sending the money to yourself, you reduce the possibility that the school automatically adjusts the student's financial aid. But be careful with your withdrawal—make sure you cover only the student's qualified expenses with the money.

You must file the distribution on your tax return, which could lead to extra penalties if not expensed out correctly.

Send Money to Your Beneficiary
If the student is responsible with money, this could help you avoid the possibility of the school reducing the financial-aid package. The student must, however, use the funds only to pay for qualified education expenses.

In the case of prepaid tuition plans, the funds must go towards purchased credits and units at their school—and nothing else. Ask yourself: do you trust that the beneficiary will do this?

Send Money to the School
This is not advisable. It might lead the school to adjust the student's financial aid award based on the amount of the 529 distribution.

If the school cuts the aid package by too much, you might end up:

  • Having to withdraw more money.

  • Covering the difference from your own wallet.

What happens if you use your 529 plan for non-qualified education expenses? Find out below.

When you withdraw money from a 529 plan, you do not have to report what you are using it for. You will report disbursements, however, on your annual income tax return.

What Happens when You Use Your 529 Plan for Non-Qualified Expenses

When not used for qualified higher education expenses, 529 withdrawals are subject to state and federal income taxes and an additional 10% federal tax penalty on earnings.

The reporting of the disbursement occurs when income tax returns are filed, not at the time the withdrawal is made. So be careful with how the disbursement is spent. You may end up owing money to your state or to the U.S. government.

You have a 60-day window to make corrections if you withdraw money from your 529 in error. As soon as you realize your error, check to see if you are still within the 60-day window. You can then:

  • Roll the funds over to another 529 plan without tax or penalty.

  • Deposit the distribution back into the 529 plan.

When the end of the year hits before the 60th day, there isn't much you can do if the money isn't re-deposited or paid back by January 31.

You will be required to pay tax and penalties when you file your income tax return. Keep in mind: You can only use the re-deposit benefit once in a 12-month period.

Let's look at qualified expenses for 529 plans in private elementary or high schools.

Tuition Plan for Private Elementary Through High Schools

529 plans are now available for eligible private elementary through high school tuition. These plans are designed for tuition only.

Books, computers, and other services or fees eligible under 529 plans for post-secondary or higher education expenses are NOT covered.

As of the 2018 tax year, you can withdraw $10,000 per student, per year, from a 529 plan to pay for elementary or secondary education.

Disbursements are withdrawn from the 529 plan by you, the plan holder. You then pay for the primary or secondary school tuition.

You are not required to report plan disbursements until you file annual income tax returns.

If you cannot prove that you used the funds for primary or secondary school tuition, you will be subject to state and federal income tax on the withdrawal, as well as a 10% penalty on your federal taxes.

Questions to Consider

These questions may help you decide if a 529 plan is right for your situation.

Will my beneficiary's expenses be covered by a 529 plan?

  • Does your beneficiary need equipment for school that is not a requirement for a course?

  • Does your beneficiary want to live off-campus in an apartment that costs more than the school's calculated allowance for room and board?

  • Does your beneficiary need help with insurance or health care costs?

  • Does your beneficiary need help with repayment of student loans?

Do you need a college savings plan with certain advantages?

  • Ease of management: You don't want to have to learn how to invest money, or you don't want to hire someone to manage investments for you.

  • Do you want to lower the need for student loans?

  • Do you want to set up savings plans for several student beneficiaries at once?

  • Does your state offer great tax advantages for 529 plans?

Do any of the 529 disadvantages stand in you or your beneficiary's way?

  • Will your beneficiary live in a different state than the school they attend?

  • Is there enough time to invest and earn before your beneficiary enrolls in school?

One critical disadvantage of a 529 plan is that it reduces your beneficiary's eligibility for financial aid. Ask yourself these questions:

  1. If contributing to a 529 account is financially difficult for you, or even if you can afford it, if your child's financial aid is greatly reduced by a 529 account, which option—the 529 plan or full financial aid—would benefit you or your child more?

  2. If you did not have a 529 account, would you be able to save otherwise?

  3. If your child was able to take out student loans to cover their education in full, would you be able to help them pay for their student loans using funds through a different type of college savings account, or with your freed-up income alone?

Bottom Line

529 plans have definite benefits. But you need to weigh your own financial needs and those of your beneficiary.

Before you make a decision, know the advantages and disadvantages as well as the benefits (and possible pitfalls) of your state's 529 plan.

Write to Mary Humphrey at evan@creditdonkey.com. Follow us on Twitter and Facebook for our latest posts.

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