We’ve been investing in 529s for our children for over a decade. Like most of you, we hope to seamlessly combine our 529s with our Coverdell Educational Savings Accounts (ESA), our Post 9/11 GI Bill benefit, scholarships, and education tax credits. With more parents contributing to a 529 plan to help pay for their child’s college expenses, I get asked about them a lot. Here are a few of the most common questions I’ve received.
Are there income and contribution limits for 529 plans?
No. There is no income limit for individuals who want to fund a 529 plan. However, your 529 contributions are limited to the amount set by your state to cover the cost of qualified higher education expenses. Don’t worry, that amount can be as high as $500,000. Additionally, If you’re eligible to contribute to an ESA, you can fund it as well as your 529.
Are there any tax benefits to contributing to a 529 plan?
It depends. Although there is no federal tax benefit, over 30 states offer a benefit for residents who contribute to a 529. This is easily researched on your favorite search engine. If you’re one of my clients, be sure to let me know how much you’ve contributed this tax year.
Does our 529 affect financial aid?
Yes. 529 plans owned by either a student or parent are considered a parental asset on the Free Application for Federal Student Aid (FAFSA). Colleges expect parents to utilize up to 5.64% of their assets to fund education expenses. This means, your child’s financial aid package will be reduced by 5.64% of the amount in your 529. For example, if you have $20,000 in your 529, your child’s financial aid will be reduced by roughly $1,128 ($20,000 x 5.64%). Ideally, with diverse investments in your 529, your tax free earnings will be greater than this reduction. This small decrease pales in comparison to the 20% reduction taken for student assets such as a Uniform Transfers to Minors Act (UTMA) or Uniform Gifts to Minors Act (UGMA). You should not report student or parent owned 529 withdrawals used to pay for college expenses on the FAFSA.
What can my 529 pay for?
- Tuition: Private elementary, private high school, and higher education for full and part-time students
- Room and Board: For full-time students only
- All on campus housing expenses
- Off campus housing is capped at the university’s cost of attendance
- Mandatory Fees: Lab fees, add/drop fees, graduation fees for full and part-time students
- Books: All purchases for full and part-time students
- Supplies: Pens, pencils, paper for full and part-time students
- Equipment: Computer, printer, software for full and part-time students
- Special Needs Services: Expenses must be connected to enrollment for full and part-time students
Are 529 withdrawals taxable?
If your total 529 distribution is more than your adjusted qualified education expense (AQEE), your child may have to pay income taxes and a 10% penalty on the excess.
Example: Chris and Crystal have contributed $15,000 to a 529 plan for their son Chad. The account has earned $5,000 in interest and has a current balance of $20,000. Based on the calculations below, if Chris and Crystal withdraw more than $5,000 from their 529 plan, Chad will have to pay income taxes at his tax rate plus a 10% penalty. If you find yourself in this situation, I highly recommend consulting a tax professional.
Total qualified education expenses $15,000*
Tax-free educational assistance -$10,000**
*see list above for qualified education expenses
**this includes scholarships, GI Bill benefits, Pell grants, employer provided assistance
What happens if my child receives a scholarship?
If 100% of your child’s qualified education expenses are covered by tax-free educational assistance or scholarships (this is typical for military dependents using the Post 9/11 GI Bill), only the earnings portion of your 529 plan withdrawal will be subject to income tax. To avoid paying the additional 10% penalty, do not withdraw more than the scholarship amount. This also applies if your child attends a military academy.
Will I get something in the mail to help me file my taxes?
Yes. If you make a withdrawal, you’ll get a Form 1099-Q from your 529 program. Box “1” on the form will show your withdrawal amount, box “2” shows the portion of your withdrawal that is earnings (interest), and box “3” shows the portion of your withdrawal that is a return of your contribution (basis).
Does it matter when I make a withdrawal and who they send the money to?
Yes. Withdrawals should be made in the same calendar year the qualified expenses are incurred. Don’t withdraw funds in December to pay expenses billed in January of the following year. Withdrawals can be sent directly to the school to avoid confusion, but can also be sent to you or your child. Be sure to keep copies of everything in case the IRS requests proof.