How to Use a 529 Plan to Manage Education Expenses

Jack says:

Now that my son is in college, I need practical tips for using my 529 saving plan. I’m wondering how much should I withdraw from it, what are the tax consequences, and if I need to save my receipts. Thanks for your help and great podcast.

Jack, I appreciate your question and want to congratulate you on being such a prepared parent! There’s a lot to consider when it comes to saving for college and helping a child create a strong financial foundation.

Whether schools and colleges open up virtually or in-person in 2020, the cost of education is incredibly high. This post will explain how to use a 529 plan to make your money go farther. I’ll offer tips for choosing the right plan, managing it wisely, and boosting your 529 contributions. 

What is a 529 savings plan?

Jack has money in a tax-advantaged account called a 529 savings plan. With these plans, you make contributions and choose investments from a menu, similar to a retirement account. Everyone can use a 529 because there are no restrictions on annual income.

Most states offer at least one 529 plan. However, the fees and benefits, such as the maximum contribution limit and investment options, vary. You typically don’t have to be a resident of a state to participate in its plan. For instance, you could live in New York, participate in a Florida 529 plan, and use the money to pay for a school in California.

No matter where you live or which state’s 529 plan you choose, your earnings in the account are tax-free, as long as you spend the funds on qualified education expenses.

No matter where you live, or which state’s 529 plan you choose, your earnings in the account are tax-free, as long as you spend the funds on qualified education expenses, which we’ll cover in a moment. Unlike a retirement account, your contributions to a 529 plan are not deductible on your federal tax return.

However, some states that collect income tax offer a deduction or a credit on your state tax return for residents who choose an in-state 529 plan. That could add up to significant savings, depending on where you live.

Therefore, the tax benefits of a 529 plan vary depending on your home state, how much account growth you receive, and which plan you choose. The earlier you start saving and investing in a 529, the more potential growth and tax savings you could have.

A major downside of a 529 plan is that if you spend it on anything other than qualified education expenses, the earnings portion of your distribution is subject to income tax and a 10% penalty. There are some exceptions when the penalty gets waived, such as if the student receives a scholarship, veteran’s educational assistance, becomes disabled, or dies.

Remember, you pay tax upfront on 529 contributions and get a tax break on the account’s investment earnings.

What expenses qualify for a 529 savings plan?

The ways you can use a 529 plan have expanded over time. It used to be only for higher education, such as college and graduate studies. You can now use a 529 for education expenses starting in kindergarten—if your plan allows it. There’s an annual limit of $10,000 per year for enrollment and education expenses at public, private, or religious schools for students in kindergarten through grade 12.

Once a student is out of high school, you can use a 529 for any college, graduate school, or vocational school, without an annual limit.

Once a student is out of high school, you can use a 529 for any college, graduate school, or vocational school, without an annual limit. But the institution must be eligible to participate in a federal student aid program, and the student must be enrolled at least half-time.

Qualified expenses include tuition, books, fees, internet access, and equipment for coursework. Reasonable room and board at boarding school or college are also qualified, but not expenses related to renting a place off-campus. If you’re unsure if a fee is 529-qualified, check with your plan provider.

How does a 529 savings plan affect student aid?

A common question is whether having money in a 529 plan counts against you when it comes to qualifying for college aid and federal student loans. Many families rely on getting financial assistance to supplement their college savings.

When a parent owns a 529 with a student as the beneficiary, the account has a small impact on how much financial aid you can get.

In general, when a parent owns a 529 with a student as the beneficiary, the account has a small impact on how much financial aid you can get. Assets owned by a student would count more heavily in financial aid calculations. Therefore, keeping a 529 in the name of a parent (or even a grandparent) is usually the best strategy. But if you have a complicated financial situation, be sure to consult with a financial advisor for guidance.

If you plan on getting federal student loans, be aware of the annual limits you can borrow. Instead of spending all your 529 money in the first years of school, spread out your withdrawals so you can meet your budget. Otherwise, you may have to turn to private student loans, which have higher interest rates and fewer benefits for borrowers than federal options.

How should you track distributions from a 529 savings plan?

Jack asked about saving receipts for educational expenses. Yes, it’s vital to keep physical or digital receipts so you can prove that your annual 529 distributions are equal to or less than the amount of your qualified educational expenses. 

Your 529 plan provider will send you and the IRS a copy of Form 1099-Q, which shows your annual distributions. If they exceed your qualified education expenses, you’ll need to report some account earnings as taxable. As I mentioned, you typically also must pay an additional 10% penalty on the earnings portion.

The most straightforward way to use a 529 plan is to pay qualified expenses first and then reimburse yourself from the 529.

The most straightforward way to use a 529 plan is to pay qualified expenses first and then reimburse yourself from the 529. You can use a money management program, such as Quicken, to tag qualified expenses and run reports on the total by any period. Just make sure your 529 withdrawals and payments occur in the same calendar year; otherwise, a distribution may be considered non-qualified. 

Another way to manage qualified expenses is to move money from a 529 to your bank account or authorize a 529 provider to make a payment. Getting funds upfront may be best when you have large bills, such as college tuition, and don’t have enough to cover it in your bank account before being reimbursed.

What happens to excess funds in a 529 savings plan?

What can be tricky about a 529 is that contributions can’t exceed your expenses. If you contribute too much to a 529, there are some ways to avoid the 10% withdrawal penalty.

Cashing out a 529 is always an option, but you’ll owe tax on the earnings portion, plus a 10% penalty.

One option for leftover 529 funds is to change the beneficiary student on the plan. For example, suppose your daughter decides to go to a less expensive college. In that case, you could change the beneficiary to your son or another family member who can spend the balance on their education.

You can also leave funds in the account in case a student eventually goes to graduate school. Another option is to use leftover 529 funds to make payments on any student loans.

Cashing out a 529 is always an option, but as previously mentioned, you’ll owe tax on the earnings portion, plus a 10% penalty. The penalty is still owned even in cases when you accidentally over-contribute to a 529.

Tips to find the Best 529 savings plan

There are many 529s to choose from, so it’s essential to shop around and compare plans. Use these tips to find the best 529 plan:

• Get familiar with the plans in your state. If you live in a state that doesn’t offer tax benefits for 529 contributions, you may come out ahead by participating in a plan outside your state. You can search for plans by state at SavingForCollege.com.
   
• Consider how much you’ll contribute. Some plans come with six-figure contribution limits, which may only be helpful if you (or other family members) make large 529 contributions.
   
• Find out your investment options. Make sure a plan has a range of investment vehicles that range from conservative to aggressive growth targets.
   
• Avoid high fees. The fee structure of plans varies, so make sure they won’t cut into your earnings.
   
• Look for convenience. Find out if a plan has user-friendly features, such as an online account and responsive customer service.
   
• Remember the bottom line. Choosing an out-of-state 529 plan with historically high rates of investment returns could be more valuable than an in-state tax deduction. 

How to boost 529 plan contributions

Once your 529 plan is open, set a goal to make regular contributions. Whether you contribute $10 a month or $1,000 a month, the sooner you get started, the easier it will be for you and your family to pay for college.

The sooner you get started, the easier it will be for you and your family to pay for college.

Why not invite other people to make 529 contributions for special events, such as a future student’s birthday or as a holiday gift? Check out GiftOfCollege.com, an online gift registry for 529 plans and student loan accounts. Friends, family, and companies can contribute online and with Gift of College gift cards or ecards.

Using a college savings registry is a smart way to share your goals, encourage participation, and hopefully make paying for college and student loans a little easier.