How to be smart about spending what you've saved
The rules for 529 savings plan withdrawals are easy to navigate with a little preparation. Know the basics to ensure a smooth path for you (the account owner) and your child (the beneficiary).
Keep the tax benefits going
Any earnings in your 529 savings plan are exempt from federal taxes. As long as you use the money for qualified education expenses within the payment year, the withdrawals won’t be taxable either. State tax treatment varies.
Withdraw funds in three steps
Step 1 – Know what's covered.
The Internal Revenue Service (IRS) term that you need to know is QEE, which stands for “qualified education expense.” Your 529 savings plan withdrawals will be free from federal tax as long as they’re used for QEEs, such as room and board, tuition, required books and supplies for higher education. There's also the option to pay for K-12 tuition (up to $10,000 a year per student), although not all states allow it. The cost of certain apprenticeship program expenses is another QEE.
You can even use 529 assets to pay for certain student loan expenses, up to a $10,000 lifetime maximum.
Using the money for nonqualified expenses could cost you federal and, if applicable, state income taxes in addition to a 10% federal tax penalty. So be sure to understand what counts as a qualified expense before deciding to spend the 529 savings plan funds on unapproved costs, such as student health fees or a plane ticket home at Thanksgiving.
States take different approaches to the income tax treatment of withdrawals. For example, withdrawals for K-12 expenses may not be exempt from state tax in certain states. Be sure to check with your tax advisor about state-specific tax benefits related to withdrawals.
Step 2 – Plan ahead.
You’ll have deadlines for paying tuition. Find out what your 529 savings plan provider will need from you to process a withdrawal, and how much time you’ll need to allow for moving the money. Look into making things even easier by linking a bank account and enabling quick transfers. The initial setup could take a week or more, but subsequent transfers will be faster.
Step 3 – Decide the details.
Next, decide the recipient: your child or the school. This will impact tax reporting. Whoever receives the funds will receive a Form 1099-Q for payment from a Qualified Education Program at tax time to report use toward qualified or nonqualified expenses. Then determine how you want the funds to be delivered: Deposit to bank? Regular mail or online?
What to do with leftover funds
What if you don’t need all that money for school after all? If your child received a scholarship, you can still access the money free of penalty. Or perhaps your child is attending a more affordable school, or room and board expenses are less than expected.
Before taking withdrawals for anything besides education, consider other options. Is your child planning on grad school? Your account can continue to grow and be used for those costs. If the child’s expenses are covered, the funds can be transferred to a 529 savings plan for a different beneficiary. You're even allowed to withdraw money for a younger beneficiary's K-12 education. Not all states offer this, however, and it may not be exempt from state taxes, so talk to an advisor before making your decision. Recent legislation has added certain student loan expenses (up to a $10,000 lifetime maximum) as a qualified education expense.
