It’s no secret the cost of college has and continues to skyrocket. It makes it very difficult to go to college debt free. This is especially true if you do not start saving early enough. If you can start saving though, you have some options. A 529 college savings plan is one of the smartest investments you can make for your child’s future success.
A 529 college savings plan is a state-administered plan. The IRS does not tax withdrawals, as long as they are made for qualifying educational expenses. As an added bonus, a 529 plan can be used for a beneficiary’s tuition expenses for elementary through high school, in addition to college, graduate school or trade school.
The rules change however, when a withdrawal is made that the IRS doesn’t consider a qualifying expense. 529 college saving plans are federally taxed, even though they are administered at the state level. If you want to use the plan to pay for a non-qualifying expense, the withdrawal will incur a 10% penalty and receive the federal tax.
That’s why you should be absolutely sure which withdrawals qualify. So here is a brief guide to assist in your decision-making on whether this type of plan is right for you.
College Savings Plans
First, the cost of attendance, including tuition and student fees, is considered a qualifying expense for a 529 plan. That’s good news because that is where the biggest expenses can be found.
Second, the plan covers room and board. But this one gets a bit tricky. So, double-check the numbers with the school’s financial aid office when calculating a qualified withdrawal.
For example, the amount you can withdraw from a 529 plan for room and board cannot exceed a certain limit. This is determined by looking at the greater of two factors:
- The cost of room and board as stated in the school’s cost of attendance for federal financial aid calculations
- The exact amount charged to the student by the university if living in on-campus housing
This means that if the beneficiary decides to live off-campus, the amount you can withdraw as a qualified expense for room and board might be much less than average rent prices.
Third, the plan covers books and supplies. This includes all textbooks required for coursework, as long as they are not optional. This expense tends to catch many students by surprise. In fact, in 2021, students spent roughly $1,240 per year on textbooks.
Finally, the plan covers personal computer equipment or software that students might need in college. To qualify, the item must be used primarily by the beneficiary for educational purposes.
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Prepaid Tuition Plans
These less common types of 529 college savings plans allow you to buy college credits at a participating university. These credits are bought at current tuition rates to be used sometime in the future. Under most circumstances, participating universities are public institutions and require the beneficiary to be in-state.
To ensure it’s a qualifying withdrawal, check with the school to verify that they participate in prepaid tuition plans. This type of plan does have limitations though. It won’t allow withdrawals for room and board or for elementary or secondary tuition.
Keep Your 529 Plan Tax and Penalty-Free
As with all financial decisions, it’s always best to discuss any type of withdrawal with your plan administrator or financial advisor. A few simple, direct questions to clarify what qualifies will help you avoid excessive penalties and taxes. This way, you won’t be blindsided by them when the plan withdrawals are reported to the IRS.
Ultimately, if used correctly and only for qualifying expenses, a 529 college savings plan plan is an excellent way to be smart about saving for your child’s educational future.
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