Thanks to exploding student loan burdens, more Americans are saving for their or their loved ones’ education. And while there are many ways to do that – from regular brokerage accounts to CDs – the top draw for that college savings continues to be 529 plans. Thanks to their tax and estate planning benefits, more than $350 billion sits in 529 plans as of the end of 2019.
But in order to get the most out of these plans and actually get the tax savings, investors need to be cognizant of what counts as “qualified withdrawals.” Not all higher education expenses fit under the umbrella of a 529 plan, including some commonplace college costs.
For savers, it’s vital that they understand what they can actually use their 529 plan for in order to avoid fees and penalties and get the most out of their overall savings plan.
Check out our state plans section here to know about the rules and regulations pertaining to each U.S. state.
Two Parts: Withdrawals & Expenses
529 plans are one of the best ways to save for college because they can offer the so-called triple play of tax benefits – that is, current tax breaks, tax-deferred growth and tax-free withdrawals. Depending on the plan, you may be able to get current state tax breaks. Meanwhile, your investments are allowed to grow tax-free, which allows for faster compounding of gains. And finally, when using the money for higher education or K-12 private school expenses, the withdrawals are considered tax-free for federal taxes.
All of this comes with a big asterisk, however. Savers need to understand how withdrawals and expenses fit under the 529 umbrella in order to not get hit with taxes and a 10% fee. And there are two parts to this equation.
The first is the withdrawal portion. Savers can’t just pull money out their 529 plan willy-nilly and in any amount. For a withdrawal to be considered qualified and free from federal income taxes, it cannot exceed your child’s so-called adjusted qualified higher education expenses (QHEEs). QHEEs essentially represent all the expenses a child would incur for the school year – such tuition and fees, room and board, books and supplies, school-related special services, and computer costs – minus any costs already covered by tax-free educational assistance. These would include Pell grants, scholarships and fellowships, tuition discounts, as well as Veteran’s Educational Assistance Programs and employer-based tuition programs.
An example of how this works would be if your school costs $20,000 for the year and you get a $5,000 Pell grant, you could only withdraw a total of $15,000 from your 529 plan and have it count as tax-free.
After calculating your max QHEE for the year, savers need to see what they can actually use that money for. The waters are a bit murky here. Nor everything you think should be covered is, and some items may be covered that you didn’t know about.
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To start with, withdrawals used to cover tuition are considered qualified and would be tax-free, as are books, lab fees, supplies and computers. But there are some caveats with these expenses. Textbooks can only count if they are required reading for the course. So, if your child takes a biology course and buys an extra book to help understand some concepts, it is not a qualified expense. The official course textbook would count.
Computers can also count, but only if they are used primarily by the student during the years they are enrolled. Any software required by a course can be included, but games or non-educational software would not count. Recently, the IRS has expanded some of the rules for computers and technology to include items such as tablets and even the cost of internet service as long as it is required by the school or course.
Living costs are where most people get into trouble when it comes to 529 plans. Room and board expenses can be considered qualified if they meet certain criteria. A student has to be enrolled in an eligible college program on at least a half-time basis for it to count. This can include the expenses for dorm living as well as meal plans offered through the college. However, items like sheets, posters, trash cans, etc. do not fall under the qualified banner and would need to come from outside sources.
Students living off campus may be able to use their 529 plan money as well. Rent, utilities and food not purchased directly from the college can qualify if they do not exceed the university’s allowance for room and board. This number can be obtained from the college’s financial aid department, but basically, it’s the total cost the school charges students living on campus as part of their overall bill.
Savers need to understand what isn’t covered as well. Fees for licensing or applications are not counted. Neither are insurance or travel costs. Bus fare, gas money or off-campus parking would not be tax-free under a 529 plan. Personal living expenses and fees for sports or club activities are also verboten. So, if your child wants to pay intramural lacrosse or get a haircut while in college, it has to come from outside sources.
A Wide Variety of Education
While most 529 plans are earmarked for university or secondary education, you can use 529 plan money for a variety of education needs and still have it count as a qualified withdrawal and tax-free.
Thanks to the recent tax-plan, savers can withdraw up to $10,000 per year per student to help pay for K-12 expenses at a private or religious school and have it count as a qualified expense. Additionally, the recent stimulus bills to combat the coronavirus has provided withdrawals for apprenticeships and other technical education costs.
Finally, post-college students can use a 529 plan to pay off a maximum of $10,000 of a student loan.
Keep Good Records
No matter what, it’s important to keep good records, receipts and other documentation when making withdrawals from a 529 plan. Come tax time, you’ll need to provide this when you file and the amount withdrawn must match exactly to the expenses paid. If your qualified expenses come to $456.65, you can’t round-up and withdraw $575 from your 529 plan. You’ll get dinged on the difference.
In the end, keeping good records and understanding exactly what is considered qualified is of vital importance to getting the most of a 529 plan. If there’s any confusion on an expense, contacting your school’s financial aid office can be a big help. The worst thing is just pulling money out without planning. And given the numerous non-qualified costs, it may make sense to have some money set aside that isn’t included in the 529 plan.
Be sure to check 529 Insights section here to learn more about 529 plans.
