Much to the dismay of students across the US, for many of them the start of the school year is less than 30 days away. We spend a lot of time as advisors helping our clients determine the best way to save college (click here if you want to schedule an appointment with one of our advisors to help you!). However, this article is for the parents who are ready to start paying for college with the funds they have accumulated in their 529 plans. As with many financial topics these days, the decisions that parents face when thinking of using the funds in a 529 can be complex. The biggest pitfall? If not done with a strategic approach in mind, it could mean excess taxes and penalties paid to Uncle Sam!
Here are some best practices that you should consider before you start paying for kiddo’s college. (Note: this article is not going to cover the recent expansion in which 529’s can be used to cover education expenses for k-12.)
Fast forward to the 7 minute mark to see his segment.
What are qualified expenses?
Withdrawals from 529s will be exempt from federal taxes if the funds are used to pay for “Qualified Higher Education Expenses” or QHEE’s. As 529s have grown in popularity, so has the list of items that are considered QHEE’s. The most popular ones are as follows:
- Tuition: As long as the school is accredited. Contact the school to determine if they are, or use this online search tool: https://fafsa.ed.gov/FAFSA/app/schoolSearch
- Room and Board-On Campus: If the student is considered half-time or more, and the room and board are paid directly to the school this is a qualified expense.
- Room and Board-Off Campus: If your child is living off campus and has a landlord, their rent may still be a qualified expense. The school the child attends can help determine the budget for off campus housing and how much can be covered by the 529.
- Books and supplies: Another budget set by the school, and of course only required books are can be paid for via funds in a 529. Some lab supplies, pens and paper may qualify. Again, contact the school directly for more information.
- Technology Items: Computers, printers, and internet service now typically are qualified expenses.
What’s not qualified?
If you pay for an expense from a 529 that is not considered “qualified”, there is an IRS penalty that will have to be paid. The entire distribution will be considered “taxable income” and there is an additional 10% penalty on the earnings portion of the distribution. The most common college “expenses” that folks try to pay for, but you cannot use the 529 for, are as follows:
- Transportation Costs: If your child needs to fly back and forth to college, you cannot pay for those expenses with the funds in a 529. Similarly, if your child needs a car to travel back and forth to school, you may not pay for any automotive expenses with the funds in a 529.
- Student Loan Payments: While this seems like an expense that one should be able to pay for with the funds in a 529, sadly you cannot.
- Insurance: Your child’s health insurance, especially those plans offered through the university cannot be paid for with funds in a 529.
- Gym Fees, club sports fees or fraternity/sorority dues: These expenses aren’t a required expense to get a college degree, and thus are not eligible.
- Dorm Room and other expenses: Sorry, but helping your child decorate their room with a TV, a mini-fridge and or any other fun stuff cannot be paid for with the funds in a 529.
Other Helpful Tips:
- Just because you’ve begun to take funds from the 529, doesn’t mean you can’t change your investment approach. For those parents who did not choose an age-based investment approach, you really should review the allocation in your child’s 529 now that you’re using the funds.
- When distributing funds from the 529, try to pay as many of these expenses as directly as possible. This will prevent any confusion on where and how the funds were spent. For those expenses that cannot be directly paid (books and computers) be sure to tell your child you MUST GET COPIES OF THE RECEIPTS!
- Expenses can only be paid via distributions from the 529 in the CALENDAR year they were charged. So don’t tap your 529 in December if the bill isn’t due until January, otherwise you may get penalized.
- If the child has multiple 529s you NEED to coordinate and consider which 529 to withdraw the funds from. A few common examples:
- If the child has multiple 529s, especially if they have different investment approaches, you should sit down and analyze which account you want to start to drain first based on the risk in their portfolio.
- If the grandparents also have 529s for the child there could be a more advantageous way to pay for the child’s college expenses by staggering the distributions between your 529 and the grandparents’. This approach is beyond the scope of this blog (again feel free to click here and schedule an appointment with one of advisors who can help!)
- If the child has a Custodial 529 and an Individual 529, again you may want to strategically think about which account to drain first. The presence of larger 529s and/or siblings would be a reason to really consider this. (For a primer on the difference between the two types of 529s: Custodial and Individual, click https://finance.zacks.com/custodial-vs-individual-529-plan-11363.html)
- Remember that there are limits on the amount in subsidized and unsubsidized loans that your child may be eligible to receive every year.
Derek Amey serves as Partner and Portfolio Manager at StrategicPoint Investment Advisors in Providence and East Greenwich. You can e-mail him at damey@strategicpoint.com.
The information contained in this post is not intended as investment, tax or legal advice. StrategicPoint Investment Advisors assumes no responsibility for any action or inaction resulting from the contents herein. Betsey’s opinions and comments expressed on this site are her own and may not accurately reflect those of the firm or of our parent company, Focus Financial Partners. LLC. Third party content does not reflect the view of the firm and is not reviewed for completeness or accuracy. It is provided for ease of reference.