What Are Qualified Expenses for a 529 Plan?
By Russell W. Hall, CFP®
It’s finally happened. After years of work and headaches, you’ve at last got a student heading to college. Perhaps they’ll be attending a local school here in Orange County, or even moving out of state. Congratulations to you and them for reaching this milestone!
Along with this big change, it’s finally time to use that 529 college savings account that you’ve been building up with your own contributions and perhaps money from family and friends. But how can you make sure that the costs you’re covering are “qualified higher education expenses”?
That isn’t a rhetorical question. As you probably know, 529 accounts (named for the section in the tax code that created them) have a great tax advantage: Earnings are not taxed if they are used for qualified expenses. But non-qualified withdrawals are subject to federal income tax and a 10% penalty on the earnings, which you usually want to avoid. Here are some tips.
1. Tuition and Fees
This seems like a no-brainer, right? After all, paying for college tuition is the main point of these accounts.
But to make sure tuition and fees can be covered by withdrawals from a 529, you first need to check if the school is an eligible educational institution. The Department of Education maintains a list of eligible schools—the Federal School Code List. At the time of this writing, the list includes over 6,500 schools (with more than 300 of those outside the U.S.), so it’s pretty comprehensive. You can also ask the school directly if they qualify.
In addition, the student needs to attend college at least part-time for many expenses to be eligible. And you cannot use the 529 to pay for costs that were already paid by grants or other tax-free assistance, or if you claimed an American Opportunity Credit or Lifetime Learning Credit for those expenses. We see a lot of confusion around that point, so check with your tax preparer if you’re in doubt.
A recent development is that the federal tax law change in 2018 allows 529 withdrawals for primary and secondary education—elementary, middle, or high school tuition—up to $10,000 per year. However, you should be aware that California doesn’t conform to that standard, and earning distributions will likely be subject to California income tax and a penalty.
We often get the question of whether it’s better to send payment to the school directly from the 529 college savings plan or pay the expenses out of pocket and then get reimbursed. Some people want to earn miles or other benefits by charging the costs to a credit card, and generally, we don’t have a problem with that as long as the charges are always paid off.
However, one strong word of caution is to keep very good records on every expense and payment made. It is rare for the IRS to investigate payments made from a 529 account, but we have seen this happen to clients, and having backup documentation is the key to avoiding unnecessary taxes and penalties.
2. Room and Board
For students who live on campus, room and board are usually included in the overall price.
For off-campus students, room and board expenses are eligible as long as the total cost isn’t greater than what the school would charge for their housing. You can confirm those numbers with the school.
Again, keeping good records is a must. Technically, the withdrawals from the 529 should be made in the same calendar year that the expenses are incurred. This can get tricky when you are reimbursing yourself, so keep it in mind as you request distributions.
3. Books, Computers, and Supplies
As we move into more of the miscellaneous expenses of college, a good rule of thumb is if an item is required for enrollment, then it is usually eligible. That applies to textbooks—if they are required reading, you should be OK.
Computers, printers, and other supplies also qualify, as long as the student needs them for school. Software would be included in that, but obviously not software for gaming or other hobbies.
A new laptop for your child, with a suite of office software, would likely be an eligible expense. A subscription to their favorite online game and a gaming headset would generally not count (although depending on the type of school, those might be required items for their coursework!).
4. Ineligible Expenses
Over the years, we have been asked about some interesting items. Here are just a few that are not eligible expenses:
Airplane tickets and travel costs
Car, health, and other insurance payments
Clothing or personal items
Entertainment expenses, like movie tickets
And a big one: Student loan payments are not a qualified expense. You don’t want to take out loans early in the college process and then hope to pay them off with 529 withdrawals later.
A Couple of Last Thoughts
If your student is getting needs-based financial aid, be careful with the timing of 529 distributions from grandparent-owned accounts. Payments made from those accounts are counted as though the student paid cash from their pocket, and can reduce the student’s financial aid going forward. To avoid that, delay withdrawals from grandparent-owned 529 savings plans until the student’s junior year, if possible.
A parent-owned 529 is included in the parent’s assets and can affect the financial aid calculation, but the resulting distributions from that account are not treated as the student’s income, so the timing is less critical. If you have both types of accounts, it will be valuable to plan out the distributions.
What if you don’t end up using the entire balance of a 529 account for college costs? Because the owner of a 529 plan can change the designated beneficiary at any time, the account could be transferred to another child’s account without tax or penalty. Or you could change the beneficiary to another family member (see the IRS’s list of eligible family members) or even to yourself if you decide to go back to school.
What’s the worst-care scenario? It is possible to make non-qualified withdrawals from the 529 account and pay federal taxes and a 10% penalty on the earnings. This is not ideal, but in some situations, it could be a reasonable course of action, especially since the account would have benefited from years of tax-deferred growth.
We hope these tips are helpful. If you have additional questions, schedule a 15-minute discovery call with a fee-only financial advisor to discuss your personal situation.