Saving for your child’s future education is a significant undertaking. While we can’t predict your child’s future, one way to save is through a 529 account designed to be for their  education costs. The logistics, rules, and best practices on how to put the funds you have diligently saved in a 529 can be somewhat mysterious. Using the 529 funds efficiently will allow you to minimize tax consequences and help fund your child’s future.

There are different approaches to saving for education costs, Coverdell accounts and 529 accounts; some even tout insurance policies as an education savings avenue. Our clients typically use 529 account balances for their child’s college costs. The appeal of 529s is the ability to grow the funds tax-deferred with tax-free withdrawals for qualified purposes. There are also state tax benefits depending on where you live. For example, Pennsylvania offers a state tax deduction for your 529 savings. Check out your state to view possible deductions.

Qualified is key

The key to maximizing your 529 funds is using the funds for costs that the IRS deems as ‘qualified.’ Most people think of 529 accounts as synonymous with college savings. However, qualified expenses for 529 funds begin as early as elementary school. You can use up to $10,000 of tuition costs for elementary, middle, or secondary school. The elementary school may be public, private, or parochial. You must use the funds for actual tuition costs; other costs, such as extracurriculars, are not considered qualified expenses. Once in college, there are many more ways a student can use the funds; each category has precise specifications to follow to be considered a qualified expense.

Tuition is the most straightforward and most common use for 529 funds in a child’s early years and in college. You may also use the funds for room and board expenses in college only. There is a caveat, the room and board qualified expense cannot be more than the greater of the following:

• The allowance for room and board included in the school’s cost of attendance for federal financial aid calculations
• The actual amount charged if the student is living in housing operated by the educational institution

For example, if your student finds a lovely apartment off campus with friends, with rent higher than the school’s estimate for housing, the excess would not be a qualified expense.

Studying abroad is a popular option, especially for junior and senior years. Room and board could be a qualified expense even when studying abroad. However, the costs to get there, the transportation, and travel-related expenses are not qualified. 

Ancillary expenses

Books and all the technology required for college add up quickly. In college only, not earlier years, books on the class-required reading lists are eligible expenses. Also, computers and related equipment used primarily for educational purposes are suitable. Students are accomplishing more and more on their phones; however, smartphones are outside the qualified expense category. If there is an expense that you are on the fence about, the financial aid office can help you determine if it is considered required and therefore fall in the qualified expense category.

Other less traditional uses for your 529 funds:  

• College students enrolled in a summer program for college credit
• College students studying abroad
• Accredited trade school programs

Spending logistics

When using the funds, you may move them from the 529 to your bank account or send them directly to the educational institution. It is entirely your preference. Many clients send funds directly to the educational institution to simplify record keeping.

You must match your 529 withdrawals with your expenses. You must keep accurate records to prove that the qualified expenses match or exceed the withdrawals. Regarding timing, the withdrawals must occur in the same year as the expense. If you take more out of a 529 than your qualified expenses, you will face a penalty and taxes. Funds you use for unqualified expenses result in federal income tax and a 10% penalty.

For example, you use 529 funds to pay for a child’s summer abroad. The trip will total $2,000 in expenses, and none will be qualified expenses. Let’s further assume you are in the 24% tax bracket, married filing jointly. Therefore you will withdraw the $2,000 of costs from the 529 accounts. You will also be liable for $480 in federal income tax plus $200 in penalties. Your child’s $2,000 trip resulted in a total of $2,680 due to improper use of the 529 funds.

The 529 accounts may impact financial aid. The impact will depend on who owns the account, their relationship with the beneficiary, and the timing of the withdrawals. Look at question five in our blog, ‘7 Frequently Asked 529 Plan Questions, ’ for the specifics on the potential financial aid impact.

Excess 529 funds

A common question we field is, what if the child doesn’t use any or all of the 529 funds in their account? The good news is that 529s are an excellent generational planning tool. 529 plans are inherited tax-free. When a 529 plan owner dies, the account gets a new owner, but since the value of the plan is treated as part of the beneficiary’s estate, it’s not taxed. The beneficiary becomes the new owner and selects another beneficiary. When the new owner dies, the 529 accounts again get passed tax-free to the next beneficiary, and so on.

Another strategy for excess or remaining 529 funds is to use the funds to pay existing student loans, specifically up to $10,000. The limit applies to student loans in the beneficiaries’ name or their siblings (brother, sister, stepsiblings). An account owner may edit the 529 beneficiaries without tax implications.

The newest possibility for remaining 529 funds, hot off the presses of Secure Act 2.0, is the option to convert funds to a Roth IRA. The new conversion is somewhat restrictive; the impact will be limited. To be eligible, the details of the account and the transfer must meet the following criteria:

• 529 plan has been in existence for 15 years or more
• Funds (and respective earnings) contributed to the 529 within the past 5 years are off limits
• Annual 529 to Roth limit is the IRA contribution limit for that year (less any regular contributions made)
• The beneficiary may transfer up to $35,000 over their lifetime to a Roth IRA in their name

 Given the limitations on the 529 to Roth transfers, we aren’t expecting to see fully funded retirements due to the new rule. Instead, please think of this new option as either efficiently using leftover 529 funds or giving a child a jumpstart on their retirement savings.

Your options for using to use funds from a 529 account are almost limitless. Ultimately, however you contribute to your child’s future, we can help you use those funds to make a positive impact. Creating a strategy for the most efficient saving and eventual use of the funds should include considerations of taxes, financial aid implications, and future benefits.

If you know someone who is considering education planning, please share this blog with them.