Back to School: Getting the Most from Your 529 Plan

If you have college-bound children or grandchildren, it’s worth learning about 529 plans.  These tax-advantaged savings plan for college expenses are named for the internal revenue code section authorizing their use.   529 plans invest after-tax dollars, ideally to grow for several years before the funds can be withdrawn tax-free, if used for qualified education expenses.  Unlike custodial accounts, the owner of a 529 savings plan, often the student’s parent or grandparent, retains control of the funds regardless of the age of the beneficiary.  If there is money left in a 529 account after the beneficiary has completed their education, the funds may be transferred to a family member.  These plans can be an excellent choice for your college savings, provided you choose the right plan, understand the rules, and keep appropriate documentation.

Choosing the right plan:

There are two types of 529 plans:  Prepaid tuition and 529 savings plans.  The savings plans are more versatile and more popular.  Each state chooses how to structure its 529 plans, and which investments to offer.  Some states such as Utah offer a variety of investment managers, and some offer only one.  529 savings plans provide a variety of portfolios, including age-based options where investment risk is automatically reduced as the child nears college age, similar to the way target date retirement funds work.  This makes it very easy for plan owners to maintain an appropriate portfolio.

With a prepaid tuition plan, your purchase future tuition at a guaranteed price, shifting the risk of rising costs from the investor to the plan.  However, for full benefits the student is limited to colleges within the state, which may not align with their plans.  These types of plans cover tuition costs only, so other arrangements must be made to pay for books, supplies, room and board. 

The 529 savings plans are more flexible.  Funds can be used at any college, university, or technical school in the US or abroad that participates in federal financial aid for students, as well as certified apprenticeship programs.  With 529 savings plans, investors are free to choose the plan that meets their needs, regardless of state affiliation, although a few states do offer a state tax advantage to residents who use their own state’s plan.  Qualified expenses include room and board as well as tuition, fees, books, and supplies. Contributions that exceed the annual gift tax exclusion are eligible for gift tax averaging, which treats one large contribution as occurring proportionally over a 5-year period.  You can find tools for comparing and choosing 529 plans here:  https://www.savingforcollege.com/.  We like the Utah plan (My529) for low costs, good investment options and ease of use.

Understanding the rules:

When it comes time to withdraw funds, most plans allow you to transfer funds electronically either to the student’s bank or directly to the school.  The 529 plan will not require you to present documentation of qualified expenses, but the IRS might.  If you are audited, you’ll need to show documentation that all your 529 withdrawals went to a qualified education expense.  If unqualified withdrawals are taken, the earnings portion is subject to federal income tax and a 10% penalty, and there may be state income tax depending on the state. 

-Both you and your student should familiarize yourselves with qualified and non-qualified expenses (detailed list follows).

–Note that Distributions must be taken in the same year the expense is incurred.  You can’t reimburse December’s rent with a distribution in January of the following year. 

-Remember that the total of all withdrawals from all 529 plans for the beneficiary must not exceed the documented qualified expenses for that beneficiary.   There are many circumstances when you might have multiple owners of plans with the same beneficiary, such as when grandparents start their own plan, parents are divorced, etc.  Owners must coordinate distributions for the year so as not to exceed the qualified amount. 

Keep appropriate documentation:

Teach your student to save receipts, cancelled checks and other evidence of funds paid out for qualified expenses.  In order to be qualified, distributions from 529 plans must not exceed this amount.  Save receipts with your tax records for a minimum of 3 years.

Qualified expenses include:

• Tuition, mandatory fees, textbooks, supplies, and other required equipment.
• Computers, peripheral equipment, educational software, and internet access.
• Room and board expenses, if they do not exceed the amount specified in the cost of attending the school where your beneficiary is enrolled at least half-time.
• Expenses for services for a special needs beneficiary.
• K-12 tuition expenses at public, private, or religious schools
• Payments on qualified education loans up to $10,000. 
• Costs for apprenticeship programs that are registered and certified with the Secretary of Labor.

Non-qualified expenses include:

• Room and board expenses that exceed amounts specified by the school.  Note that costs estimated by the school for off-campus housing may not reflect what’s available in a competitive housing market.  Your student’s actual costs may be substantially higher.  Rent in summer months is only qualified if the student is enrolled in the summer.
• Cell phone plans
• Travel and transportation expenses
• Insurance costs
• Sports, entertainment, fraternity and sorority expenses

In exchange for careful planning, record-keeping and rule-following, families receive the benefit of tax-free appreciation, which can be a significant advantage over the years.