With the cost of college tuition increasing an average of 8% each year, it pays to start saving as early on as possible. Section 529 plans, also known as qualified tuition plans, offer parents a relatively easy tax-advantaged way to save. Every state offers at least one 529 plan option and anyone can contribute, regardless of income. If you’ve established a 529 plan to pay for college, it’s important to know how you can and can’t use the money to cover back-to-school costs.
There are two types of 529 plans: college savings plans and prepaid tuition plans. Prepaid tuition plans allow parents to pre-purchase tuition credits at in-state colleges and universities. A separate private prepaid tuition plan also exists for parents whose children plan to attend a private institution. Money in a college savings plan can generally be used at any accredited college or university.
For either type of 529 plan, you must use the money to pay for expenses at an eligible educational institution. The IRS defines an eligible institution as any college, university, vocational school or another postsecondary school that is eligible to participate in federal student aid programs. You can also use 529 funds to cover costs at foreign institutions that participate in aid programs administered by the U.S. Department of Education.
Parents can use 529 savings to cover a wide range of college expenses, including tuition and fees, books, supplies, and equipment, including computer equipment, Internet access and equipment required by students with special needs. The IRS also allows you to use a 529 plan to cover the cost of room and board for students living on or off-campus. For room and board expenses to qualify, the student must be enrolled at least half-time and the total amount cannot exceed the cost of attendance as determined by the school.
Tax treatment of 529 plans
Withdrawals of 529 plan funds are tax-free as long as they’re for qualified expenses. Some states allow you to deduct your contributions to their 529 plan but there is no deduction available at the federal level. It’s important to note that contributions may be subject to federal gift tax if they exceed the annual limits. As of 2012, you could contribute up to $13,000 without incurring a tax penalty if single and up to $26,000 for couples.
If your child receives scholarships, grants or other tax-free education assistance, the amount of your 529 plan distribution that is not taxable is reduced by the amount of aid they receive. You can use money in a 529 plan to cover college costs in the same year that you claim the Lifetime Learning Credit or the tuition and fees deduction, as long as the money is not used for the same expenses. The same is also true if you plan to take a distribution from a Coverdell ESA to pay for some of your child’s educational expenses.
Tax penalties for nonqualified distributions
If you use the money in your 529 plan to pay for things like clothing, entertainment or anything other than education expenses, the distribution is subject to regular income tax on any gains and a 10% tax penalty unless there are extenuating circumstances. You can avoid the 10% penalty if:
- The designated beneficiary dies and the money is distributed to their estate or to another beneficiary
- The designated beneficiary becomes disabled and is incapable of pursuing their education
You can also avoid paying income tax or the additional penalty if you change the designated beneficiary or roll the money over to a new 529 plan for another beneficiary. Rollovers must be completed within 60 days of the distribution in order to offset the 10% penalty.
The tax benefits of 529 plans make them an attractive option for parents who are looking for the best place to stash away cash for future educational expenses. Using your 529 plan wisely can help to reduce your out-of-pocket costs and potentially help your child to avoid the pitfalls of student loan liability.