State-sponsored savings plans are a great tool for covering the daunting cost of tuition and more, but you need to follow the rules or the tax man will get you.
Parents, grandparents and others who have used 529 college savings plans to help young family members with the costs of college, vocational or trade school deserve a hearty pat on the back for their discipline and sacrifice.
This fall, if your student is moving on to further schooling, it’s time to crack those piggy banks and use the money. The rules aren’t complicated, but they are picky. Here’s a look at what you can and cannot spend the funds on and a quick recap of the rules.
First, though, a brief recap of how these state-sponsored plans work. Parents, grandparents or anyone else can establish a 529 plan to fund a child’s post-high-school education.
Your money goes into the account after taxes. The funds, including earnings on the investments, are withdrawn tax-free as long as the money is spent on certain “qualified” school-related expenses.
Here’s more on how to set one up and grow the money:
- “Everything You Don’t Know About 529 College Savings Plans“
- “Question: How Do I Invest My Kid’s 529 College Savings Plan?“
The rules are precise, and mistakes are costly
Be very careful how you spend the money in a 529 account. The special tax treatment it enjoys depends on spending the funds according to certain rules.
I asked Gregg R. Wind, a CPA and partner in the Los Angeles CPA firm KTL, how this works. Wind and his wife, also a CPA, own two 529 accounts for their daughters, in college and high school.
Wind says the trick is making sure the money is used for “qualified” expenses and documenting the spending in case your taxes are audited.
A mistake can be expensive. “Let’s say, for example, that over a 10-year period I put $50,000 into an account, and it’s now worth $60,000. If I take out the money and use it for some other purpose — to buy a house, say — the earnings, $10,000, are subject to tax as income and also subject to a 10 percent penalty,” Wind says.
The IRS calls 529 plans “qualified tuition programs.” But, in fact, the funds can be used for other school-related expenses. Spending in these eight categories are OK as long as you can show the IRS the appropriate documentation in case you are audited.
Also, students must be enrolled at least half-time in an eligible education institution. If the school is on the U.S. Federal Student Aid Code List, it’s probably eligible. To be certain, ask the school if it will send your student a Form 1098-T, evidence of attending an eligible educational institution.
Reporting expenses to the IRS
At the end of the year or in January you’ll get a tax form from your 529 plan’s administrator showing what’s been distributed. As long as you spent at least as much as you received from the plan on qualified expenditures, the distributions are not taxable as income.
Keep all receipts, including the form that your student’s school sends showing what you’ve paid them. That’s your proof for the IRS.
Expenses that qualify
The IRS says eligible expenses include “tuition, fees, books, supplies, and equipment required for the enrollment or attendance of a designated beneficiary at an eligible educational institution.”
With that in mind, here are eight possible ways to use 529 funds:
- Direct-pay: Ask your plan’s administrator (the company — Vanguard, for example — chosen by your state to run its 529 plan) to send a check from your plan account directly to the school
- Withdrawal: Have the plan administrator send the tuition amount to you, and you write the check to the school.
2. Books: Textbooks and other coursework materials are eligible expenses.
3. Fees: Fees for school-related expenses — a gym-class locker, lab equipment or other course supplies — are eligible if required for a course.
4. Room and board: The cost of on-campus housing and meals qualify if your student is in a dorm or other campus housing. Contact the school’s student financial aid office to learn the charge for room and board per semester (or quarter).
5. Off-campus housing: If your student lives off campus in an apartment or elsewhere, rent can be covered with 529 funds. “As long as the (rent) amount isn’t more than it would have been in the dorm, it qualifies,” Wind adds. “Under audit, you would have to show some information from the school and maybe use your canceled checks to show what you paid in rent.” You might even be able to fund room and board while studying abroad if you follow these rules.
6. Groceries and restaurant meals: When a student is not living in a dorm, the cost of groceries and even restaurant meals can qualify — but, again, only up to the cost of a dorm meal plan. If dorm food costs $400 a month, for example, you can spend up to $400 a month on groceries and meals from a 529 fund.
7. Equipment: It seems reasonable to interpret a computer as something “required for study,” Wind says. “Generally, that means a laptop,” he adds. But a desktop or tablet may meet the test — if it is required.
Other equipment may also qualify. For instance, if an accounting class requires students to buy a certain kind of calculator. In lab classes and studio classes, students typically are handed a list of supplies to purchase. Those may be covered. Keep receipts and the list for tax records. Read this IRS article on Qualified Tuition Programs, and when in doubt consult a CPA.
8. Supplies and services: Some supplies and services may qualify, too. The cost of internet access, for instance. The IRS might argue that students can use a computer lab, Wind says, but you may be able to make a case that owning a computer is common practice on campus and that instructors require students to log into course websites, communicate with faculty electronically and perform research online. Course-related software may be another a qualified expense, depending on class requirements.
If there’s money left
It’s possible that, at the end of college or trade school, the account has a balance. You can’t withdraw it without paying tax on the earnings plus that 10 percent fee.
But you can transfer the balance to a qualified member of the beneficiary’s (your student’s) family. Any family member counts — a sibling or even a first cousin. Or you can leave the money in the account to grow for an eventual grandchild. Or use it yourself to return to school — at least half-time, of course.
What’s your experience covering college costs? Share with us in comments below or on our Facebook page.