Using Funds From a 529: Important Things to Know

The cost of higher education continues to increase, with the average cost of college now hovering around $38,000 per student per year, according to the Education Data Initiative. The good news is that there are practical ways to set money aside for college that also come with tax benefits—such as a 529 plan.

Before opening a 529 plan for a dependent child, however, there are some things parents and guardians should know about what these plans entail and how to withdraw the money from a 529 wisely.

What Is a 529 Plan?

Specifically, a 529 plan refers to an educational savings plan that is sponsored by an individual state (usually, the state where the dependent lives). This type of plan is designed to help parents, guardians and dependents set aside money to pay for educational expenses down the road. A 529 can be opened at any time, but starting early is the best way to maximize the gain on the investment.

How 529 Plans Are Taxed

From a tax perspective, contributions made to a 529 plan are typically taxed at both the federal and state levels (though this can vary from one state to the next). However, most states offer some kind of tax deduction or credit, either as a one-time credit or on a recurring basis. This credit is usually a percentage of the amount contributed to the 529, which can help to offset taxes.

It is also worth noting that when a student withdraws funds to use for qualifying education expenses, the money is not taxed at the federal level as long as the withdrawal doesn’t exceed the student’s adjusted qualified higher education expenses (QHEEs).

529 Best Practices

People may contribute to a 529 plan for many years before a dependent actually needs to withdraw funds from the investment account. However, it’s important for account holders to understand what to expect when it does come time to use those funds for school. By withdrawing money wisely, it is possible to maximize tax benefits while minimizing the potential for penalties or other obstacles.

Below are some of the most important things to keep in mind when preparing to use 529 funds to pay for school.

Understand Qualified Expenses

First, account holders should take some time to understand which educational expenses qualify for using 529 funds, as not all do. Generally, there is a limit of $10,000 per year per beneficiary, which may not be enough to cover all educational expenses for a student.

What are considered qualified expenses? Typically, these include:

• Tuition and fees
• Room and board (in most cases, though there are exceptions)
• Textbooks required for classes
• Computers and related tech/equipment

Knowing which expenses are considered “qualified” is important because if funds from a 529 are used for a non-qualifying expense, this could result in taxes and an additional penalty of up to 10%.

Plan Carefully for Withdrawals

There are also different ways to withdraw and use funds from a 529 account, so this needs to be taken into consideration as well. One option is to withdraw the money and have it sent directly to the school to cover educational expenses. Another option is to move the money from a 529 account into a personal bank account.

Regardless of the option chosen, it is important to plan ahead. Funds can take several days (or more) to process and transfer, so requesting the withdrawal with plenty of time to meet payment deadlines is a must.

Keep Receipts and Detailed Records

Last but not least, 529 account holders should be especially diligent about recordkeeping. Most plans will provide account holders with an annual statement covering their contributions, earnings and withdrawals. However, account holders are the ones responsible for keeping records of all their withdrawals and spending. This way, if any issues arise, it is possible to show proof with a receipt or other documentation.

What’s Next?

Opening a 529 plan can be a great way to start saving for a dependent’s higher education—especially since the funds from a 529 can be used not just at colleges and universities, but trade schools and other educational settings as well. The key, of course, is to understand how to make withdrawals in such a way that maximizes tax benefits and avoids potential penalties or interest. In doing so, account holders can help their students get the most out of their 529 plans and ease the burden of paying for a higher education.

If you have any questions or would like additional information, please contact our investment planning team.