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Common Questions About Spending 529 Funds

From the time your child is born all the way until college, there are myriad opportunities to set aside money for college. If you’re like many Americans, you might have started a 529 plan and contributed to it faithfully over the years. So when it comes time to fund a college education, how do you go about spending the money you’ve saved?


Qualified Tuition Programs: an Overview

Also known as qualified tuition programs (QTPs), 529 plans allows you to prepay or contribute to an account designated solely for covering a student’s postsecondary education costs. Prepaid tuition plans entitle the student to a waiver or a payment of qualified education expenses.


Neither payments nor contributions to a QTP are deductible. However, once a distribution occurs from a QTP, no tax is due, provided the distribution is not larger than the beneficiary’s adjusted qualified education expenses. Furthermore, the student or the student’s parents might qualify for the American Opportunity Credit or the Lifetime Learning Credit. Learn more about QTP specifics in Chapter 8 of IRS Publication 970.


Each QTP has different guidelines according to the state agency or eligible educational institution that established and maintains it. Check with your state’s government or your desired educational institution to find out which QTP options are available to you.


How May Funds Be Used?

Upon distribution, the funds in a 529 account typically may be applied toward tuition, fees, books, supplies and other education-related expenses. Students attending school at least part time may also have room and board covered. Provided the funds are used for the above qualified purposes, there is no federal income tax on investment gains.


How Do 529 Plans Affect Financial Aid?

529 plans are considered parental assets and are therefore factored into federal financial aid formulas, up to a maximum of roughly 5.6 percent. As such, only up to 5.6 percent of 529 assets are included in the expected family contribution, or the amount that a family is expected to pay toward the student’s educational costs.


What If the Account Is Owned By a Nonparent?

In cases where the 529 account owner is not a parent (a grandparent, for instance), the 529 account is not reported as a student asset on the Free Application for Federal Student Aid. However, any distribution from such a plan is reported as income to the beneficiary.


In this case, the end result can be a reduction in eligibility for need-based aid in the following year. Consult with your tax adviser on when to use these funds; oftentimes, it makes sense to use them in the last year of college after submitting the final financial aid forms.


How Does a 529 Plan Compare to Other College Funding Options?

With no income or age restrictions, 529 plans are an easy way to save for college without the limits of certain other types of education savings accounts.


Whereas the Coverdell ESA restricts annual contributions to $2,000, 529 plans have no annual limit. They also only cap contributions once the account reaches a certain value, which varies by state. You have a range of conservative, moderate and aggressive age-based investment strategies from which to choose.


Furthermore, the 529 plan allows for a sizable cash gift to the beneficiary. It can be given as a lump sum but treated as if it’s being gifted over a five-year period. Any gifts in excess of $14,000 annually must be reported to the IRS and counted toward the individual’s lifetime gift-tax exclusion limits (currently around $5.4 million per individual by federal guidelines).


Are There Penalties for Not Using the Funds Toward College?

A 10 percent penalty and ordinary income taxes on earnings apply if you don’t use 529 funds toward qualified higher education expenses. If the beneficiary for whom the account was intended decides not to go to college, you can avoid the penalties by transferring the account to a college-bound beneficiary.

It’s always best to check with your tax advisor about the best way to set up and use 529 accounts. He or she can help you look at your specific financial situation from every angle to find out the best course of action.

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