For most investors, the 529 account is the most used account type to save and invest for a child’s education. This type of account provides for tax-deferral on the growth of the investments and if the funds are used for ‘Qualified Educational Expenses’ the funds can be withdrawn tax free.
If you have a young one either in school or about to head off, you are likely wondering what exactly is a qualified education expense that allows the withdrawal to be tax free.
What is a Qualified Education Expense?
As long as the funds are being used for a college age child, there is no limit on the amount of qualified expenses that can be incurred. 529 funds can now be used to cover expenses for a child in grades K-12 but those expenses are limited to $10,000 per year and only tuition and fees qualify.
Qualifying expenses include:
- Tuition and Fees (Limited to $10,000 per year for K-12)
- Room and Board (Student must be enrolled at least half-time)
- Books and Supplies
- Computers, iPads, Internet, Software
What is not a Qualified Education Expense?
While many costs associated with school, and often the highest cost expenses, are qualifying educational expenses not all are and it is prudent to be prepared to cover non-qualified expenses through other means. Some common expenses that can’t be paid from a 529 penalty free include:
- Transportation – including purchasing a vehicle, airfare to and from school, gas and maintenance
- College Application & Testing Fees – Including SAT and ACT
- Club Fees – Including Fraternity/Sorority Dues (though housing costs can qualify), intramural costs
- Health Insurance
How Should I Pay for Qualified Expenses?
Depending on the total cost, frequency, and complexity of various expenses there are generally three ways that people will pay for qualifying expenses. Keep in mind, you must withdraw the funds in the same year the expense was incurred so if you are not paying the expense directly from the 529 you will want to ensure proper timing of the distribution.
For major bills that are large dollar amounts and happen infrequently – think tuition bills, one time dorm fees, etc. – a check can be written and sent directly from the financial provider that holds the 529 to the recipient. For example, at the start of the school year we will often line up tuition payments and send them directly to the university referencing any items needed to ensure payment is applied correctly.
For smaller items or those that occur frequently, you can request the funds be sent in advance of the expense (if known) or to reimburse yourself or your child after the expense has been incurred. It may be difficult to know in advance what the cost of books and supplies will be – often clients will pay those expenses as incurred, save the receipts, and then request a reimbursement from the 529 for the total.
Costs like monthly rent, that are known in advance, can be requested and sent ahead of time to ease the burden of covering costs with other funds. This can also give your child some experience managing their own finances – receiving their funds in their bank account, establishing auto-pay if available or writing a rent check each month.
What Documentation Should be Kept for Tax Purposes?
While there is no requirement to “prove” an expense was incurred in order to take a distribution from a 529, you will receive a 1099-Q tax form each year detailing the distributions that were taken from the plan and noting what amount represented the accounts basis and earnings.
As with any tax reportable event where you may need to provide proof of an expense, you will want to keep good records in case of an audit. For expenses directly from the school – tuition, fees, potentially room and board – the 1098-T tax form can be a good resource to save. You can also save the bills sent by the school, bookstore, housing provider, etc.
How Should I Prioritize Spending if my Child has more than One 529?
This situation most commonly arises if an older sibling finishes school and has excess funds. In this situation, the beneficiary on the older sibling’s 529 can be changed to a younger sibling to be used towards their qualifying costs.
When this happens, it will generally be prudent to use the 529 with the larger proportion of earnings first. 529’s used for non-qualifying expenses are taxed only against the earnings so eliminating the earnings on qualifying expenses minimizes the tax bill if there are funds leftover after all the kid’s are through school and the remaining funds are withdrawn in a non-qualified manner.
The other common situation would be if both parents and grandparents establish a 529 for the same child. In this case, distributions from the grandparent-owned 529 can be considered income on the child’s FAFSA and affect financial aid. Assuming the child is on pace to graduate in four years, you can wait until the spring of their Sophomore year to take withdrawals from the grandparent-owned 529 and the income will not count against their undergraduate FAFSA’s.
What Other Tax Strategies Should I Consider?
There are two major tax incentives offered by the federal government to help with the costs of college expenses. If you plan to utilize either of these credit’s, you will want to ensure that expenses are paid with non-529 funds.
American Opportunity Tax Credit provides a credit equivalent to 100% of the first $2,000 of expenses followed by 25% of the next $2,000 for a total potential tax credit of $2,500. To qualify for the full credit in 2024 a single filer would need a modified adjusted gross income below $80,000 and a married couple filing jointly would need to be below $160,000.
Lifetime Learning Credit provides a credit equivalent to 20% of qualified expenses of to $10,000 for a maximum credit of $2,000. To qualify, your modified adjusted gross income must be below $80,000 if single or $160,000 if married filing jointly in 2024.
Paying for a child’s education can be complicated and confusing. If you have questions about your specific situation, please schedule a meeting and we are happy to review your options. It is always prudent to discuss tax credits with your tax preparer to ensure you understand the implications as they pertain to your situation.
Keep Reading: What is a Donor Advised Fund?
As with other investments, there are generally fees and expenses associated with participation in a 529 plan. There is also a risk that these plans may lose money or not perform well enough to cover college costs as anticipated. Most states offer their own 529 programs, which may provide advantages and benefits exclusively for their residents. Investors should consider, before investing, whether the investor’s or the designated beneficiary’s home state offers any tax or other benefits that are only available for investment in such state’s 529 college savings plan. Such benefits include financial aid, scholarship funds, and protection from creditors. The tax implications can vary significantly from state to state.
While we are familiar with the tax provisions of the issues presented herein, as Financial Advisors of RJFS, we are not qualified to render advice on tax matters. You should discuss tax matters with the appropriate professional.
