We’ve been investing in 529s for our children for almost two decades. Like most of you, we hope to seamlessly combine our 529s with our Coverdell Educational Savings Accounts (ESA), Post 9/11 GI Bill benefits, 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 annually. Additionally, if you’re eligible to contribute to an ESA, you can fund it in addition to 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.
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). Roughly speaking, the amount over $10,000 reduces your child’s financial aid package by 5.64% of that total. For example, if you have $30,000 in your 529, your child’s financial aid will be reduced by roughly $1,128 ($30,000 – $10,000 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 the 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, vocational/trade school, and college for students enrolled at least half-time ($10,000 per year limit for K-12)
- Room and Board: For students enrolled at least half-time
- 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 students enrolled at least half-time
- Books: All purchases for students enrolled at least half-time
- Supplies: Pens, pencils, and paper for students enrolled at least half-time
- Equipment: Computer, printer, software, and internet access for students enrolled at least half-time
- Special Needs Equipment: For students enrolled at least half-time
- Student Loans: $10,000 lifetime limit
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. Tax-free educational assistance that affects your AQEE includes tax-free scholarships and fellowship grants, the tax-free portion of the Pell Grant, employer-provided assistance, and Veterans’ educational assistance.
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. Chad received a $10,000 tax-free scholarship. Based on the calculations below, if Chris and Crystal withdraw more than $15,000 from their 529 plan to pay for non-qualified expenses, Chad will have to pay income taxes at his tax rate and a 10% penalty. If you find yourself in this situation, I highly recommend contacting one of us.
$25,000* Total qualified education expenses
-$10,000 Tax-free educational assistance received
*see the list above for qualified education expenses
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.