Which Expenses Qualify for Your 529 Plan?March 24, 2021
A 529 plan is a special type of savings account you can use to pay for qualifying educational expenses.
When you deposit money into a 529 plan, your money grows tax-free. As long as you withdraw the funds for qualifying educational costs, distributions are tax-free as well. Most states offer their own 529 plans, and many states also provide additional tax benefits, including the option to make tax-deductible contributions.
Unfortunately, if you withdraw 529 money for anything other than 529 plan-qualified expenses, you will face a 10% federal tax penalty as well as state and federal taxes on the withdrawn gains. As a result, it’s important to understand which expenses are eligible for 529 plans.
College Savings Plan vs. Prepaid Tuition Plan
529 plans are generally categorized in one of two ways: as prepaid tuition plans or traditional savings plans. Here’s how they differ:
- Traditional Savings Plan: The money you put into these accounts is invested in mutual and money market funds. Often, you’ll have the chance to make portfolio selections when you open the account, so you can have some control over the amount of risk you want to assume. If your investments do well, these accounts can generate strong growth over time. On the other hand, you may lose some of your 529 funds if the value of your portfolio drops.
- Prepaid Tuition Plan: These accounts can be a great choice if you know your child will pursue college at an in-state, public school. Their greatest benefit is that you can lock in the price of tuition at the time of payment. For example, your child is going to college in 5 years, but you pay for a semester now, even if tuition doubles or triples between now and their start date, their tuition will be considered paid in full for that semester.
What are 529 plan qualified expenses?
529 plan qualified expenses are expenses that you are allowed to pay tax- and penalty-free with money withdrawn from your 529 account.
Your qualifying withdrawals are tax-free as long as the total amount you take out of your account during the year does not exceed annual qualified higher education expenses (QHEEs) for the year in which the withdrawal was made.
What are eligible expenses for 529 accounts?
529 plans eligible expenses include:
- Up to $10,000 per beneficiary per year for K-12 expenses such as tuition for elementary, middle, or high school students attending a private, public, or religious school
- Tuition and fees for a college, university, vocational school, post-secondary institution, or another program that’s eligible for federal student aid issued by the Department of Education
- Room and board costs, but only up to the actual amount charged if the student lives in housing provided by the school; or up to the amount of the room and board allowance included in the school’s cost of attendance
- Textbooks that are considered required reading for an academic course
- Computers, equipment, services, and software as long as it is predominantly educational in nature and as long as the equipment is primarily used by the beneficiary while attending an eligible educational institution
- Up to $10,000 to make student loan payments – this is a lifetime limit, and it applies to each 529 account beneficiary.
To make sure you comply with the rules regarding eligible expenses for 529 plans, you should keep all receipts for purchases you believe are eligible. You should also make purchases for 529 plans eligible expenses separately from purchases that do not qualify.
You must also make sure to use the money in the same year that you take a distribution from the account, and keep careful records. Your 529 savings plan administrator will provide an annual summary of distributions. You need to make sure that the qualified higher educational expenses you report equal or exceed this amount to avoid a tax penalty.
It’s also important to be aware that any expenses that you used to claim the Lifetime Learning Credit or the American Opportunity Tax Credit cannot be paid for with 529 funds. In other words, you cannot double-dip on these tax benefits.
How to pay for 529 plans eligible expenses
You can pay tuition directly to an eligible financial program, or you can move money from your 529 to your bank account or brokerage and then use the funds to pay 529 plan-eligible expenses.
You can also arrange to have the distribution sent directly to your child if they are the beneficiary of the account. However, just be sure your child uses the money for allowable purchases. If your child uses the money for non-qualified expenses, there will be tax consequences. However, since your child’s tax rate is most likely going to be lower than yours, this approach could reduce the IRS bill if some of the money is spent on non-qualified purchases.
A 529 account can be a great way to pay for educational expenses. These types of accounts vary by state but often have several tax benefits providing they’re used correctly.
Before taking a distribution from your 529 plan, be sure you’re using the money to cover eligible expenses. That way, you can enjoy the full range of benefits the account offers.
Keep in mind that you should always keep a record of the purchases you’ve made with 529 funds since you’ll need to accurately report these numbers on your taxes. Understanding how 529 plans work can help you to manage your educational expenses more effectively.