Parents and relatives looking to the future are doing what it takes today to ensure their loved ones can afford postsecondary education.
Paying for college is not an easy task, but the good news is you have access to several investment vehicles when it comes to saving for education. One of the more popular ones is the 529 plan. Given the sharp increase in the cost of attendance, much emphasis has been placed on why you should save into a 529—but not on how spending the money works when the time comes.
A 529 college savings plan specifies what is considered an eligible expense. Understanding how to spend from your account will help you make the most of your investment.
You should have a plan for spending these funds as it will help make the most of your savings, ensuring tax advantages are protected and that you won’t pay unnecessary fees or penalties.
What Is a 529 College Savings Plan?
A 529 college savings plan is a state-sponsored investment plan that allows the beneficiary (i.e., student) to pay for qualified higher education expenses. The money is tax-free when used to pay for qualified college costs. A few tax advantages, both federal and state, may come along with the 529 plan.
These plans are popular because they allow people to save for education with extreme flexibility and low to no minimums. While every state except Wyoming offers a 529 plan, you can invest in a plan from any state, though you should look into in-state tax benefits as some plans are more favorable than others.
The assets from the plan can similarly be used at any eligible school in the country and abroad (find a full list of eligible institutions here), so you are not limited by state. A 529 plan can be used for college, university, graduate school, vocational school, and technical school, providing many options for your child, grandchild, or other beneficiaries.
While there are two types of 529 plans, this article will focus solely on the 529 saving plans. The conventional savings plan invests after-tax dollars into a portfolio of funds similar to a 401(k). As the investment grows, it is not taxed. The gains are also not taxed when withdrawing money for qualifying expenses.
Your state may even offer various tax credits on contributions, adding additional tax benefits.
Paying for Postsecondary Tuition with a 529 College Savings Plan
You have two ways to pay for postsecondary tuition with a 529 savings plan. You can withdraw the funds as an eligible expense and pay the college. Or you can have the 529 plan pay the college directly, with no family withdrawal in between.
Paying the college directly from the 529 plan can be helpful in terms of clearly showing the IRS that the expense is education-related. When the funds move from the plan to the school directly, there is no question that you used it for qualified educational expenses. The paper trail is as direct as possible.
On the other hand, withdrawing the funds yourself and then paying the school can help clarify matters for financial aid. Some institutions might inadvertently see a direct 529 payment as cash support, which can hurt financial aid eligibility.
Overall, it is important to keep good records of how you spend 529 money. You never know when the Internal Revenue Service might audit you, necessitating documentation to show how you spent the funds. Keep organized and ensure you can vouch for every dollar spent.
Qualified 529 Expenses Outside of Tuition
While school tuition is an obvious choice for using funds from a 529 account, you have many other options.
You may be surprised to learn that 529 funds can go toward rent and utilities for off-campus students. The amount is covered up to the cost of the school’s housing allowance, which can usually be found through the financial aid office. These expenses must have been incurred during an academic period in which the student was enrolled or accepted in a program.
Eligible 529 expenses outside of tuition also include on-campus housing, of course. Meal plans, required fees, books, supplies, and even computers are covered as eligible expenses. Essentially, anything that is required for enrollment or attendance at an eligible college or university counts.
You may also be surprised to learn that up to $10,000 a year can be withdrawn, tax-free, to pay for K-12 education. A 529 college savings plan can help students long before they attend postsecondary education. This fact can also be useful when there is money left over from the original beneficiary’s education and you have an eligible beneficiary in a K-12 school.
A 529 plan does not cover some common costs as an eligible expense, an important consideration for anyone saving for college. Application and testing fees are not eligible, so things like CLEP, college test prep, and ACT/SAT are not covered. In addition, extracurricular activities along with transportation costs are not covered.
The American Opportunity Tax Credit (AOTC) offers those eligible federal tax credits up to $2,500 per year per student for the first four years of college. The amount of the credit is 100% of the first $2,000 of qualified education expenses and 25% of the next $2,000. The key here is that you can’t double-dip the tax breaks—that is, you can’t claim the credit for the same expenses you paid with tax-free money from your 529. For example:
Sarah is eligible for the maximum AOTC of $2,500, which means she had at least $4,000 of qualified education expenses in the calendar year. If her education expenses total $12,000, Sarah may withdraw $8,000 ($12,000 - $4,000 used to generate the AOTC) tax-free from her 529 plan.
If you are concerned about the eligibility of a particular expense, get in touch with your plan administrator or financial advisor. Our Bethesda, MD fee-only financial planning firm works with clients to help ensure that their costs are eligible so that they do not incur unwanted fees or penalties.
Market Volatility
A common concern for investments is how to handle market fluctuations. Thankfully, 529s provide some flexibility to deal with this concern. When enrolling, there are two common strategies:
Age-based portfolio: This is an investment approach where your asset allocation of stocks, bonds, and cash automatically changes over time. This strategy helps protect your 529 assets from being subjected to large drawdowns since the percentage gradually shifts from equities to bonds and cash when the beneficiary approaches college age.
Static option portfolio: This investment approach is not programmed, and your asset allocation remains the same unless you change it. This approach can come in handy for those who have a higher risk tolerance or want more investment control. A common strategy is to carve out a portion (e.g., one to two years of estimated expenses) to a more conservative investment as the beneficiary gets closer to college-age, which allows the aggressive investment portion additional years of growth for the beneficiary’s junior and senior years.
What to Do If You Withdraw Too Much
A common question is what happens if you withdraw too much money because you overestimated the amount you needed for an eligible education expense.
Typically, you can avoid taxes and penalties if you re-contribute the money within 60 days of its withdrawal. In extreme situations like 2020 and COVID-19, the IRS gave plenty of leeway with a temporary extension after colleges issued refunds for campus closures.
Still, it’s a good rule of thumb to replace the funds as soon as possible to lessen the risk of penalty.
What if your beneficiary doesn’t go to college or receives a scholarship? Is the 529 rendered useless? Far from it. We addressed these topics in a prior post.
Seeking financial advice is always recommended as it helps reduce stress and costly mistakes. Waiting until the last minute to make key financial decisions is never a good idea.
Discuss your situation with a fee-only financial advisor.
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