Anyone with children can relate to the ever-present feeling that you should be actively planning how you’re going to pay for their education.
One of the most popular tools that families use to save for education expenses is the 529 plan. Yet despite the popularity of the 529 plan among college savers, it’s still something that produces a lot of questions, including the most frequently asked questions below.
1. What is a 529 plan?
While 529 plans are named after section 529 of the federal tax code, they are operated by the states and some higher education institutions. There are two types of 529 plans: Savings Plans and Prepaid Tuition Plans—and each receives different treatment.
Prepaid Tuition Plans let you pre-pay all or part of the costs associated with attending an in-state public college. These savings may also be converted for use at private and out-of-state colleges under certain circumstances. The Private College 529 Plan is a separate prepaid plan for private colleges, sponsored by more than 250 private colleges.
College Savings Plans work much like a Roth 401(k) or Roth IRA. Contributions are made on an after-tax basis in mutual funds or similar investments. The account will go up or down in value based on the performance of the investment options, but the earnings grow tax-deferred. Distributions that are used for qualified educational expenses are tax free, however, expenses used on non-qualified expenses are taxed at ordinary income tax rates and carry an additional 10% penalty.
2. What is a “qualified expense” for a 529 plan?
The definition of what constitutes a qualified education expense has evolved over time. Initially, qualified 529 Plan expenses were limited to post-secondary costs like tuition and fees. It’s since been expanded to include K-12 education expenses (by the 2017 Tax Cuts and Jobs Act) and registered apprenticeship programs (by the Setting Every Community Up for Retirement Enhancement Act, known as the SECURE Act), in addition to textbooks and equipment needed for attendance. For example, in past years, computers were not considered a qualified expense, but a recent rule change allows you to use your 529 plan to purchase a new computer and any software without penalty if it is required by your education program and will be used primarily for education purposes.
Students that are enrolled at least half-time and are seeking a degree, certificate or other recognized credential can use 529 plans to pay for room and board. For students who live off campus, 529 plan withdrawals for living expenses can’t exceed the school’s published on-campus room and board cost estimates.
Health insurance and transportation are only considered qualified expenses if the college charges them as part of a comprehensive tuition fee or if it is a fee that is “required for enrollment or attendance.”
The table below helps identify qualified expenses, but if you’re unsure whether an expense is qualified, you should contact the IRS or your financial advisor.
|Type of Expense||Is it a qualified education expense?|
|Tuition and fees||Yes, up to the full amount of tuition and required fees for college, graduate, vocational and trade schools that are eligible to participate in the federal student aid program. Limited to $10,000 per year for public, private or religious K-12 schools.|
|Books and supplies||For college expenses only—schools will set the budget limit for books and supplies, so check with the institution.|
|Computers and internet access||For college expenses only—must be required as part of attendance, so check with the institution.|
|Software||Yes, for software that is required as part of your education.|
|Room and board||For college expenses only, if the student is enrolled at least half-time. Off-campus housing and food are qualified up to the cost of room and board on campus.|
|Special needs equipment||Yes, for certain services and equipment that may be required for attendance.|
|Transportation and travel costs||Generally no|
|Health insurance||Generally no, including health insurance policies offered by a school.|
|College application and testing fees||No|
|Extracurricular activity fees||No|
|Student loans||Yes, up to $10,000|
|Apprenticeships||Yes, the apprenticeship must be registered with the federal Labor Department.|
3. Can grandparents contribute to a 529 plan?
Often 529 plans are set up by grandparents rather than by parents or guardians, which can create income tax deductions in some states for the grandparents. However, there could be financial aid implications if the 529 plan is in the grandparents’ name.
Money saved in a grandparent-owned 529 account does not affect a student’s financial aid eligibility as long as the funds remain in the account. But once withdrawn, the distribution counts as student income and can reduce the student’s eligibility for need-based aid by as much as half of the withdrawal.
One way to avoid that happening is to consider transferring ownership of the plan to the beneficiary’s parents before distributing any money for a more favorable financial aid treatment. If that isn’t an option, it may be best to wait until January of the beneficiary’s sophomore year to withdraw funds. Since the FAFSA uses income from the last two years, waiting that long will mean there aren’t any financial aid implications (assuming the student graduates in four years).
4. What if there is money left over in a 529 Plan?
One of the most common concerns when opening a 529 plan is having unused funds if the beneficiary doesn’t attend college or if there are funds left over after graduation. The truth is, despite the best-laid plans that might end up happening. For example:
- A family has several children, each with a separate 529 account. One sibling attends a less expensive college or trade program and does not use the full balance in their account.
- A student graduates in three years instead of four, perhaps by taking summer courses or earning advanced placement credit.
If that’s the case and you have a 529 plan with extra funds, there are few options at your disposal, including these common strategies:
Transfer to another beneficiary.
You can change the beneficiary to another qualifying family member without tax consequences. For instance, if you have another child attending college or a niece or nephew that needs help with a private K-12 education. However, try to avoid skipping a generation as that could trigger a tax penalty. Since 529 plans can also be used to pay for continuing education, you could even make yourself the beneficiary and continue your own education.
Save for your child’s future educational needs.
Even if your child decides not to immediately pursue a four-year degree, 529 plan funds can be withdrawn to cover qualified expenses at any eligible post-secondary institution, including vocational or technical schools. Beyond that, you may decide to keep funds in the 529 plan account in case your student wants to continue on to a graduate or professional program.
Make student loan payments.
Thanks to the SECURE Act, which passed in December 2019, families are now allowed to take tax-free 529 plan distributions for student loan repayment. There is a lifetime limit of $10,000 per beneficiary and $10,000 for each of the beneficiary’s siblings (including stepsiblings).
Save the 529 plan for a grandchild.
Since there is no time limits imposed on 529 plans, you could leave any unused money as an educational legacy to your grandchildren. This is a unique opportunity for estate planning, since the value is removed from your taxable estate but you retain control of the account. However, it should be noted that under certain circumstances there could be tax implications for skipping a generation, so be sure to discuss this with a tax specialist or financial advisor.
Take advantage of penalty-free scholarship withdrawals.
If your child gets a scholarship, you can withdraw up to the amount of the award to spend on anything you like without penalty. However, keep in mind that you need to pay income tax on any gains. To avoid paying any taxes, you can save the money for future use or transfer to another beneficiary as mentioned above.
Use the funds for non-qualified expenses (with a penalty).
If you truly have no other use for your leftover savings in your 529 plan, you can withdraw the funds for everyday expenses. However, you won’t receive the full value of the funds. Although your contributions will never be taxed or penalized since they were made with after-tax dollars, any earnings on your investments will be subject to regular income tax and a 10% penalty.
While 529 plans are perhaps the most popular method families use to save for college, they are by all means not the only strategy available. If you have questions about starting or strengthening your college savings plan, this is the time to speak to an advisor who can help pinpoint the best strategy for you.
Prior to investing in a 529 plan, investors should consider whether the investor’s or designated beneficiary’s home state offers any state tax or other benefits that are only available for investments in such state’s qualified tuition program.
ChFC®, Series 7 Securities Registration,1 Series 66 Advisory Registration, † Insurance License Brent has been advising Wealth Enhancement Group clients since 2007. As a believer in the power of teamwork, Brent often leverages the vast knowledge and resources of Wealth Enhancement Group to provide great service and smart strategies to his clients. Specializing in values-driven planning and retirement income planning, he takes pride in his ability to listen...Read More