Senior Wealth Advisor & Co-President, Colony Sports and Entertainment
August 19, 2019
As parents and their children prepare for the fall semester of college, one of the most frequently asked questions we get is about their college 529 funds—specifically what they are allowed to spend those dollars on.
Because 529 accounts are tax favorable, they have strict rules on what the money can be used for, when the withdrawals must be used and what happens if you take out too much. These funds can also affect a student’s financial aid, so it’s a good idea to get the facts first to avoid any unforeseen problems. To help clear up any confusion, we’ve put together this handy guide outlining the rules for qualified 529 expenses.
As long as 529 plan withdrawals are used for “qualified higher education expenses” (QHEE) during the year in which they are withdrawn, account earnings are tax-free. If money from a 529 plan is used for anything that does not meet the “qualified expense” criteria, the earnings portion of that non-qualified distribution will be taxed as ordinary income plus a 10% penalty. Exceptions to the 10% penalty rule pertain to a beneficiary who becomes disabled, attends a US Military Academy or gets a scholarship. The principal portion of any withdrawals, which is made up of your after-tax contributions, will never be taxed or penalized.
What is a 529 Qualified Higher Education Expense (QHEE)?
Students must be enrolled as a full time or minimum half-time student at an accredited institution. 529 plans can be used to pay for two and four year colleges, vocational and technical schools, graduate school programs and some international schools as long as they are an eligible 529 institution based on their Federal School Code (Federal School Code Lookup for Section 529 Eligible Institutions).
The list of QHEE’s is not long and you should not have a problem, if you stick to the list below.
529 Qualified Expenses:
2. Room and Board: On-campus dormitory room and board is a qualified expense. Off-campus housing and meal costs are eligible up to the college’s published allowances in their “cost of attendance” figures.
Caution: 529 Funds used to pay for rent or meals in excess of the specific allowances published by the college’s annual cost of attendance (typically found online from the admissions or financial aid office) are not qualified expenses. If the student’s expenses are higher than the allowable amount, the difference must be paid from funds that do not come from the 529 account.
3. Fees: Administration, lab and technology fees required by the school
4. Books and Supplies: So long as they are required – this includes pens, paper, printer ink, etc. as required by specific classes.
Caution: The school will set the budget for books and supplies so check with them for the allowed amount.
5. Technology: Computers, software, printers, internet services and other programs required by specific classes that are purchased and used while a student in is college.
6. Additional expenses of special needs beneficiaries: These include certain services and equipment that a special needs student would require like wheelchairs and transportation costs which are generally considered a non-qualified expense.
Caution: It’s a good idea to check with your accountant or financial advisor before contributing to a 529 account for a special needs child because the benefits they receive from the government, like Supplemental Security Income, restrict the income and assets owned by the beneficiary to qualify.
While outfitting that college dorm can be expensive, it does not count as a qualified expense. Here are other expenses that you should not consider in your 529 withdrawal as they won’t count either.
Expenses that are NOT Qualified:
1. Transportation and travel costs to and from campus such as airfare, gas and auto expenses.
2. Health and Life Insurance: No, even if they are offered by the university.
3. Student Loan Repayment: No, if a student has college debt, they cannot use their 529 savings to pay it down. Instead, use as much of the 529 savings to pay for college expenses up front to avoid having to take out unnecessary loans.
4. Cell phones and other electronics: While some electronics, such as computers and printers are eligible expenses, cell phones, mobile plans and electronics for personal use are not eligible.
5. College application and testing fees: No
6. Club and extracurricular activity fees, including fraternity and sorority membership dues: These are not eligible.
7. Lifestyle and personal expenses: Mini refrigerators, laundry and personal expenses are all not eligible.
Financial Aid Implications and Scholarships:
Since 529s can affect the financial aid a student receives, it’s important to coordinate these 529 plans to maximize their financial aid benefits. 529 plans owned by a student or parent receive favorable treatment on the FASFA (Free Application for Federal Student Aid) which is used to calculate a student’s Expected Family Contribution (EFC) in determining how much federal student aid the student may be eligible to receive.
The value of a 529 plan owned by a dependent student or parent is considered a parental asset on the FASFA and will reduce the student’s aid package by a maximum of 5.64% of the asset value. So if a parent has a 529 account worth $50,000, their child’s potential financial aid award would be reduced by $2,820 (i.e., 5.65% x $50,000). In comparison, a custodian account under UGMA/UTMA, will be counted as a student asset and reduce the aid package by 20% of its value. In the case of a $50,000 UTMA account, this would result in a potential $10,000 student aid reduction which is significantly less beneficial.
Plan ahead if there is more than one 529 account for a student applying for financial aid, particularly if the 529 account is owned by a grandparent or other relative: It’s not uncommon for grandparents or other relatives to fund 529 accounts. Withdrawals from these third party 529s will be treated as income to the student on the FAFSA in a future year and can reduce the financial aid amount by 50% of the 529 withdrawal. It may be advisable to wait and use these third party 529 accounts for a later year of college (when a student no longer needs to file annual FAFSA) or graduate school. Learn more about how 529s affect financial aid.
If your child receives a scholarship, you basically have three options for your 529 plan: (1) use the 529 plan for qualified expenses not covered by the scholarship, including graduate school in the future; (2) direct the 529 to another family member-beneficiary such as a sibling; or (3) withdraw the like-amount of the tax-free scholarship from the 529 plan, penalty-free, and pay income tax on any earnings.
Timing is everything: The 529 withdrawal must be used to pay for QHEE’s in the same year so you need to make sure to match same year withdrawals with expenses. Be careful not to pay tuition in January with 529 money that was drawn in December of the previous year. You can ensure proper matching by requesting that the distribution from your 529 plan be sent directly to the school bursar.
If you take too much money: It’s not uncommon to take a 529 distribution only to discover that your student doesn’t have enough qualified education expenses this year. There are two options: prepay next year’s expenses, or roll over the excess into another 529 account if you catch it within 60 days of withdrawing the funds. Keep in mind that rollovers are limited to one every 12 months.
Avoid tax surprises: The burden of proof for tax purposes is on the 529 owner so it’s best to keep copies of all college payment statements and support in case you get audited.
Ask for help: As you tap into your 529 accounts, don’t be afraid to ask for advice from your financial advisor or CPA if you want to be sure about the best way to withdraw and apply these funds.
Lastly, starting January 1, 2018, you can withdraw up to $10,000 per year per child from a 529 plan to pay for tuition only for K-12 schools.
There is one more very important thing you should do before sending your young adult off to college – have them sign some important legal documents such as a Health Care Proxy and HIPAA Authorization that will allow you to act on their behalf in case of emergency. Read Essential Documents Your Young Adult Children Should Sign to learn more.