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529 plan rules529 college savings plans offer several tax benefits and the potential to build your child’s college fund over time. Unlike with several investment accounts, the federal government allows your 529 plan earnings to grow tax-free. Your withdrawals will be tax-free as well if you use them to pay for qualified higher education expenses. But you need to understand 529 plan rules. What constitutes a qualified expense and what are the penalties for making a nonqualified withdrawal? Read on learn how you can maximize your 529 benefits and avoid pitfalls. 

529 Plan Tax Rules

When you don’t use 529 plan money on qualified expenses like tuition, you’re making a nonqualified withdrawal. The earnings portion of your withdrawal will face federal income tax at your bracket plus a 10% penalty. The IRS may also require you to pay back any previously claimed tax deductions on your contributions in addition to state income tax on the earnings portion of your withdrawal.

How does your earnings portion break down? It depends on the size of your account at the time you made the nonqualified withdrawal.

Let’s say you contributed $14,000 toward your 529 plan and it grew to $20,000 in six years. This means 70% came from your contributions and 30% came from investment returns earnings. If you then make a $10,000 nonqualified withdrawal, 30%, or $3,000, will face federal income tax at your bracket plus a 10% penalty. If you’re in the 24% federal income tax bracket, you’ll owe a 34% tax penalty on that portion of your withdrawal.

The state tax penalty regarding nonqualified withdrawals would depend on the laws in the state you pay your taxes. So you might need to seek a certified public accountant (CPA) or financial advisor in your state to measure the ultimate impact of a nonqualified withdrawal. But whatever the cost, it would erode the savings you’ve invested into your child’s educational future.

The federal government does provide you with some wiggle room. You can withdraw your own contributions penalty free anytime, because you made them with money that had already been taxed.

You should talk to your advisor to discuss ways you can find an alternative if you’re really considering tapping into your child’s college fund. He or she can also help you understand the benefits of your 529 contributions. In most states, your 529 contributions will constitute some form of tax deduction or tax credit up to certain limits.

529 Plan Rules by State

Contrary to popular belief, you don’t have to enroll in a 529 plan sponsored by the state you live in. Your child doesn’t need to enroll at a college in the state that sponsors your plan. Any U.S. citizen or resident alien with a valid Social Security number or tax identification number can open a 529 plan account.

You can open an account in Vermont for someone who lives in New York and ends up going to school in California.

However, states that sponsor 529 plans set their own contribution limits, which vary across the country. They usually stretch from about $350,000 to $500,0000.

529 Plans and Gift Tax Rules

What are the 529 plan rules?

When considering 529 plan rules, it’s important to know that the federal government treats 529 plan contributions as gifts toward the beneficiary for tax purposes. As of 2018, you’d trigger a gift tax if you contribute more than $15,000 to an individual in a year. The same applies to a married couple filing jointly that makes a contribution of more than $30,000.

However, 529 plans offer a kind of exception. Individuals can contribute $75,000 and married couples can transfer up to $150,000 per year toward a 529 plan, as long as contributions are paused throughout the next five years. This rule basically stretches out the gift tax exclusion throughout five years. So say you contribute $50,000 one year. The IRS treats it as $10,000 contributed through five years. So you could contribute up to $25,000 over the next four years without incurring a gift tax.

If a donor dies within that five-year period, a portion of the contribution will be included in his or her estate for estate tax purposes. Making this decision serves as another crucial point to consider alongside a qualified tax advisor.

529 Withdrawal Rules

Sometimes, people are hesitant to open 529 plan accounts because “qualified higher education expenses” seem like a difficult part of the tax code to understand. But it’s not that complicated this part of 529 plan rules. You can take a glance at some common and important examples below.

  • Tuition and mandatory fees at eligible schools, which include community colleges, universities, trade and grad schools.
  • Room and board expenses paid directly to the school for a student enrolled at least half time.
  • Off-campus room and board for a student enrolled at least half time and as long as the price doesn’t exceed the estimated cost of living on campus. You can find these details on school websites or through their financial aid offices.
  • Books and school supplies necessary for enrollment in college courses. Syllabi would list these.

You should also know what aren’t qualified expenses. Below are some examples.

  • Transportation to and from campus
  • College insurance policies and medical expenses incurred at college
  • Campus health club memberships
  • Fees paid toward school-sponsored clubs even if they’re educational in nature

With that said, you should also reach out to the financial aid office at the school your child is enrolled at to determine the expenses you’d need to cover for a given academic year and whether they’re qualified.

In addition, you’d need to report 529 plan activity such as transactions and withdrawals to the IRS come tax time via the form 1099-Q. To make it easier, we’ve reviewed the best tax software to help you automate your return.

529 Plan And Scholarship Rules

Yes, your child can use a scholarship to pay for college expenses without jeopardizing any 529 plan savings. In fact, you can make a nonqualified withdrawal in the amount of a tax-free scholarship while avoiding the 10% penalty. The IRS also waives the 10% penalty if your child attends a U.S. military academy. However, you will still owe federal income tax and possibly state income tax on the earnings portion of the withdrawal.

But what if your child receives a full-ride scholarship? You don’t have to give up your savings. Your child can potentially use them to cover qualified expenses at grad school if he or she chooses to attend. You can even switch the beneficiary to anyone in your child’s immediate family without penalty.

529 Plan Rules And Financial Aid 

Opening a 529 plan may affect your child’s eligibility for federal financial aid to a certain degree. However, the impact is generally minor and depends on several factors such as the identity of the account holder. It’s vital to understand the nuances of 529 plan rules on this front.

When a custodial parent serves as the account holder, the government will treat the 529 plan as a parental asset when the student fills out a Free Application for Federal Student Aid (FAFSA). But only a maximum of 5.64% of the account value will be factored into the student’s Expected Family Contribution (EFC). The U.S. Department of Education uses this formula to determine a student’s federal financial aid eligibility.

But if a student saving for college is the account holder, the plan will count as his or her own asset. A larger maximum of up to 20% of the money in the account will be factored into the student’s EFC.

Just how much of those maximums will get factored into the EFC will depend on other factors such as outside assets and household income.

But when someone with a different relationship to the beneficiary opens a 529 plan account—such as an aunt or grandfather— the plan’s balance won’t count as an asset at all. Distributions for qualified higher education expenses will be considered the student’s untaxed income when he or she fills out additional FAFSAs.

The federal government treats assets and income differently when considering financial aid eligibility. This means two students with similar financial situations but a different relationship to the people who opened 529 plans for them could get drastically different financial aid packages.

Overall, a 529 plan has the smallest dent on a beneficiary’s financial aid eligibility when the custodial parent opens the account. But don’t worry. Family and friends can contribute toward the plan as well. And some states even allow them to make tax-deductible contributions.

529 Plans and K-12 Rules

The Tax Cuts and Jobs Act or Trump Tax Plan allows you to use up to $10,000 in a 529 to fund tuition at private, religious and even public K-12 schools per year. However, lawmakers are analyzing how to treat these withdrawals for state tax purposes. So keep your eye on how laws evolve in your states around the topic with regard to 529 plan rules.

The Takeaway

529 plans offer several benefits, but you have to follow a few rules. To make the most out of tax perks, you should use your 529 plan funds on only qualified educational expenses. But as long as you play by the rules, the IRS will let you enjoy all the benefits of 529 plans. Try to cut corners and the government may hit you with some penalties.

Tips on Following 529 Plan Rules

  • Seek a financial advisor to help you follow the 529 plan rules and make the most out of your savings. If you don’t work with one already, you can use our financial advisor matching tool to find an advisor who meets your needs. It will ask you some simple questions about your financial situation before connecting you with a few local advisors based on your preferences and financial goals. You can then review their credentials and set up phone or in-person interviews.
  • Know what qualified expenses are. Your financial advisor and a representative at the school’s financial aid office can help you determine what your 529 plan investment does and doesn’t cover tax free.
  • You can now use your 529 plan money to cover up to $10,000 in tuition at certain K-12 schools. However, these are qualified at the federal level. Lawmakers are still working out how to treat these withdrawals for state tax purposes. So keep your eyes on how the news around this story develops in your area.

Photo credit: ©iStock.com/Wavebreakmedia, ©iStock.com/Ankabala , ©iStock.com/Photobuay.

 

Javier Simon, CEPF® Javier Simon is a banking, investing and retirement expert for SmartAsset. The personal finance writer's work has been featured in Investopedia, PLANADVISER and iGrad. Javier is a member of the Society of American Business Editors and Writers. He has a degree in journalism from SUNY Plattsburgh. Javier is passionate about helping others beyond their personal finances. He has volunteered and raised funds for charities including Fight Cancer Together, Children's Miracle Network Hospitals and the National Center for Missing and Exploited Children.
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