How You Can Use A College 529 Plan

One day your child is born, and it feels like the next day he or she is heading off to college. I remember when my kids were born — I thought kids were expensive then! Now, with a child in college and another one getting close, the expenses are mounting up. Like most of our clients, we funded a 529 plan to help defray college expenses. The 529 plan allows tax-free growth if the funds are used for education. However, it’s important to know which expenses qualify.

• K-12 private school tuition and fees, up to 10K/year
• College tuition and related fees
• Room and board
• Books and supplies
• Computers and related equipment
• Repayment of student loans – up to a maximum of $10,000

These qualified expenses are adjusted by subtracting the amount you receive from Pell grants, tax free scholarships, and the lifetime learning credit. For example, if your tuition and fees are $15,000, and your student receives a $5,000 scholarship, you can only withdraw 10,000 tax-free dollars from your 529 plan.

Of course, like all IRS rules, this one has exceptions and clarifications, and not all expenses qualify. Tuition and fees are required expenses and are allowed, but with room and board, the costs can’t exceed the greater of the following amounts:

• The actual amount charged if you are living in school-provided housing
• The allowance for room and board included in the school’s cost of attendance for financial aid calculations.

This rule makes sense; otherwise, wealthy parents would fund 529s to allow their kids to live in penthouses with butler services … all paid with tax-free dollars! These stipulations make how much you can withdraw less ambiguous.

Textbooks count as a qualified expenses, but only if the course requires them. Computer equipment is qualified, but only if students use it during their matriculation at the school. Software is also qualified, but not games. Sorry, Minecraft fans!

The IRS has also stated certain items that are clearly not qualified expenses:

• Insurance payments – home, health, etc.
• Sports expenses or monthly club dues
• Electronics and smart phones
• Room and board in excess of the school’s on-campus costs
• Transportation and travel expenses

To the extent possible, we always recommend you pay expenses directly to the educational institution from your 529 plan versus reimbursing yourself. This method is much easier from a tax return standpoint. Of course, qualified expenses are allowed, but simply keep in mind you have to keep good records in the event of an audit.

Most people have a lot of questions about education plans. Here are some of our most frequently asked questions, along with some answers:

• What if my child doesn’t go to college?

In that case, you can withdraw your principal (the amount of money you invested), tax free. The gains in the account are subject to taxes at regular tax rates and a 10% penalty.

• What if my child gets a scholarship?

In this case, you can take out the amount up to the scholarship without a penalty, but the taxes on the earnings would still apply.

• What if I have money left over in the plan?

In this situation, you can roll the assets over to another child, use it yourself if you are educationally inclined, or for other immediate family members. You have to change the plan beneficiary to use it for someone else.

• Do 529 plan contributions affect student loans and aid?

Generally, 529 plans have a minimal effect on either of these funding sources. 529 plans are considered parental assets (kids are plan beneficiaries, not owners), so they are treated as any other parental asset, like a brokerage/savings account, for instance.

• Should I use 529 plan money first, or borrow money and use that first?

If the loan interest is waived while the student is in school, borrowing first may make sense. If the interest is capitalized (meaning added to the loan balance), then you may want to use 529 plan assets first and borrow in later years, once the 529 plan money is exhausted.

• What happens if I get tax credits for education on my tax return (American opportunity credit or Lifetime learning credit)?

You can’t double dip. In other words, you can’t use the 529 plan for the same expenses that qualify you for the credits. Therefore, you want to be careful to maximize how you use the credit each year. However, most individuals making more than $80,000 (couples over $160,000) wouldn’t qualify for these credits anyway.

Raj Chokshi