The 529 college savings plan is one of the best ways to set aside money for your children’s college education. The plan offers a host of features that make it an attractive option for savers, including sizable tax breaks and deductions just for doing something that’s already valuable for a future college student. And now the 529 plan offers benefits for others, too, including those attending private schools as well as those paying down student loans.
Here’s how to tap the account when it finally comes time to start using it and some guidance for taking optimum advantage of it.
6 tips for making qualified withdrawals on your 529
1. Follow the withdrawal rules scrupulously
The key to avoiding costly penalties and additional taxes is to follow the rules of your 529 plan carefully. While a 529 plan is broadly the same across the U.S., specific rules may differ in each state’s plan. So it’s critical that you follow the rules, especially around withdrawals.
The 529 plan explicitly states that earnings can be withdrawn from the account tax-free “when used for qualified education expenses of the designated beneficiary, such as tuition, fees, books, as well as room and board at an eligible education institution,” according to the IRS.
The key word here is “qualified,” because it limits the kinds of expenses that are eligible.
“Avoiding withdrawal penalties depends on distinguishing qualified and unqualified expenses,” says Judith Corprew, executive vice president at Patriot Bank.
Besides such qualified expenses as tuition, fees, books and room and board, the IRS also allows a few other expenses, such as computers and software used by the student, says Corprew. “Devices used primarily for entertainment are not, such as a TV,” she says.
And while some expenses are associated with going to school, that doesn’t make them qualified expenses for a 529 plan.
It’s also important to note that changes to the 529 plan in recent years have expanded what counts as an eligible expense.
In 2017, the Tax Cuts and Jobs Act allowed 529 plans to pay for K-12 tuition at private schools. Then in 2019 the SECURE Act allowed a 529 to pay up to $10,000 of the beneficiary’s student loans as well as an additional $10,000 for the student loans of each of the beneficiary’s siblings.
The 2019 act expanded eligible expenses to include qualified apprenticeship programs, allowing distributions for textbooks, fees and equipment related directly to these job-training programs.
Also not to be overlooked: Your institution must be eligible. You can search for your school on this federal school code list to ensure that it does meet the requirements of the program.
2. Save those receipts
You may feel like trashing those receipts once you’ve submitted a form to be reimbursed, but experts suggest that you hang onto them.
After you know what expenses are qualified, “the next step to think about is to save your receipts,” says Logan Allec, CPA and owner of personal finance site Money Done Right. “By saving your receipts, you can now prove that you spent what you claimed.”
Allec explains that keeping these receipts will help you minimize the pain at tax time, because you’ll have the documentation you need to justify your claims.
“You don’t need to submit your receipts with your tax return, but you will need them if you ever get audited, and they are helpful to you when preparing your return,” says Allec.
3. Have the college paid directly
When you’re ready to withdraw money for a qualified expense, you could send it to the student, who could then pay the amount to the school, or you could also have the 529 plan transfer the money to the college directly. Sending it directly is an easy way to avoid a potential misstep.
“When preparing to make withdrawals, I would strongly encourage parents to arrange whatever payments possible to go directly from the 529 to the institution,” says Urban Adams, investment advisor at Dynamic Wealth Advisors in Orange County, California.
“Your 529 provider’s withdrawal form should contain fields to have funds distributed in this manner. Always save a copy of those withdrawal forms,” says Adams.
This approach cuts out the possibility of any middle person getting in the way of the distribution, and it clears the lines of communication between the administrators of the 529 plan – who have done this countless times – and the institution being paid.
4. Spend the money in the same tax year as it was withdrawn
With a fall semester and a spring semester, a school year spans two calendar years. Meanwhile, a tax year occurs only within one calendar year. That mismatch can cause a tax headache inadvertently.
“If you withdraw money from a 529, then you need to spend the distributed money on qualified expenses that year,” says Allec.
One way to run afoul of 529 rules here is by withdrawing a full year’s tuition at the start of the school year but only paying the fall tuition. While you may have every intention of having the money ready to pay spring tuition, it won’t look that way to tax authorities. They’ll see an unqualified withdrawal and will be ready to hit you with penalties for not using the money in the same tax year as it was taken out.
“Make sure to keep a log of exactly how much you took out of the plan and how much you’ve spent,” says Allec. “This way you can make sure all money is spent within the year.”
Experts suggest that setting up the 529 plan to pay the institution directly can also help alleviate the possibility of withdrawing too much, and he suggests hiring an accountant to manage the withdrawals.
5. Parents can get paid, too
While 529 plans are typically thought of as reimbursing students for qualified expenses, parents can also be paid back, too. But they’ll want to document everything carefully.
“For other qualified expenses that parents paid for outside of the 529, complete the withdrawal form to have the distribution sent to the parent,” says Adams. “But save all receipts for those other expenses and match them with the distribution form.”
Again, to save a nightmare later, keep track of all money being spent and reimbursed from the account.
6. Watch out for 529 plan issues due to COVID
COVID upended things for college students, many of whom were sent home or chose to forgo a semester or two of school temporarily, while the situation normalized. Here how’s a few different scenarios might affect your withdrawal strategy:
- If your plan’s beneficiary takes a semester or year off: Your 529 plan will be available when you need it, so you don’t need to use it by a specific date. You can resume regular withdrawals when you have qualified educational expenses.
- If your plan’s beneficiary takes a reduced course load: A student must take at least a halftime load to qualify for the 529 plan. If the beneficiary meets that threshold, you can take distributions for expenses without concern.
- If your plan’s beneficiary is taking classes via remote learning: A 529 plan can be used for expenses directly related to an eligible educational course, including computers, software, internet access and similar equipment.
- If you receive a refund from the educational institution: First, you could use the money toward other qualified educational expenses during the same calendar year, as long as you’re otherwise following the plan’s rules. Second, you could replace the unused money back into the 529 plan, but you must do so within 60 days of receiving it from the educational institution. In this latter case, the money will count as a current-year contribution to the account.
If you’re unable to spend already-disbursed money on qualified expenses or cannot replace it in a timely manner, any earnings that have been withdrawn will be subject to state and federal taxes and penalties.
So it’s important that you clearly understand the ramifications of any withdrawal, especially if it’s under unusual circumstances. And as you would do for a withdrawal in a normal situation, be sure to collect receipts that document your actual qualified expenses.
What are the pros and cons of a 529 plan?
A 529 plan offers numerous advantages to those saving for education, but it does have some key drawbacks that you’ll need to consider:
Advantages of a 529 plan
- It helps you save for education with tax benefits. The plan allows money in the account to grow tax-deferred, and many states offer their own tax benefit, allowing you tax deductions or credits against your state taxes.
- Funds can be withdrawn tax-free. Money in the account may be withdrawn tax-free if used for qualified education expenses at eligible institutions.
- Many plans allow you to invest in higher-return assets. You may be able to invest in individual stocks or stock funds, giving you the opportunity to amass more money than you could in most investments. If you have several years until the funds are needed, compound growth can work its magic on your 529 plan, letting your money earn money. So you’ll want to look around for the best 529 plans to see what’s available.
- The plan has a lot of flexibility. Part of the beauty of the plan is that anyone can establish and contribute to one. That allows parents, grandparents, other relatives and even friends to pitch in. As part of the Tax Cuts and Jobs Act of 2017, a 529 plan can also be used to pay for private school tuition for kindergarten through high school, too.
- The plan’s scope has expanded. The 2019 SECURE Act also allows funds to be used to pay off student debt, up to $10,000 for the plan’s beneficiary and up to an additional $10,000 for the student loans of the beneficiary’s siblings. The plans can also be used for qualified apprenticeship programs, while a 2017 change now allows the funds to be used for K-12 tuition at private schools.
- You can change the beneficiary. If the original plan beneficiary won’t use the money for qualified purposes, you can switch the beneficiary to someone who may. And you can switch it multiple times, if you need to.
Disadvantages of a 529 plan
- You may not get tax benefits for another state’s plan. If you sign up for another state’s 529 plan, realize that you’ll only get tax benefits in your own state if you contribute to that state’s plan. You’ll get benefits in the other state only if you also pay taxes there.
- Your state may not offer a tax benefit even for its own plan. Not all states offer a tax benefit for their own 529 plans.
- You can lose money in a 529 plan, depending on the investment. If you invest in market-based assets such as stocks, stock funds and bonds, among others, you can lose money. Only FDIC-backed products are protected against loss.
- Investment options can differ markedly among plans. Your choice of investible funds, stocks or other vehicles is up to each state’s plan administrator. So you may not be able to get the investment options you want with your own state’s plan.
- If not used, the money will have to be withdrawn and you may owe taxes and penalties. If the money in the account cannot be used, you’ll have to withdraw it and pay taxes on any gains. The good news is that you can hold the account open as long as there’s a living beneficiary, and the beneficiary can be changed indefinitely. So you have time to shuffle things around to avoid the downside.
- The investment options can be confusing. Many 529 plans offer a range of investment options, and you may need to pick without the benefit of an expert. So you’ll want to understand their risks and rewards as clearly as you can.
- Prepaid tuition plans are good only at the specific institution. If the plan beneficiary doesn’t go to the institution where the prepaid plan was established, the plan will not be useful, though you’ll still be able to access the cash stored in it.
Those are the biggest advantages and disadvantages of 529 plans.
It can’t be stressed enough how critical it is to follow the rules of the 529 plan that you sign up for — and those rules differ from state to state. If you run afoul of the rules, it could cost you in taxes and penalties, money that could otherwise go to something valuable.
So while it’s tempting to jump right in, try to take a measured approach and understand the best course for adding money to the account, as well as how to access the account when it comes time to use the money.