I am often asked this question – Should I just use my son’s 529 plan to pay for all of the first year of college? The answer is “Probably not”.
What is a 529 plan?
A 529 plan allows you to contribute funds to an account on an after-tax basis. The growth on the funds can be withdrawn without being subject to federal income taxes if the funds are used for qualified education expenses. In some states the 529 withdrawals for qualified education expenses won’t be subject to state income taxes. Additionally, some states permit a tax deduction for certain contributions to 529 plans.
Which distributions are tax-free?
First, distributions from 529 plans can be free of federal income taxes if used for qualified education expenses. For example, qualified education expenses include tuition and fees. Room and board expenses for housing operated by the educational institution qualify. For students living off-campus, expenses up to the amount that room and board would cost if the student lived in housing operated by the school will qualify. Required textbooks are qualified expenses. Computers and related equipment such as printers and monitors are qualified expenses if they are used primarily by the student during the time that the student is enrolled at school.
What expenses are not qualified education expenses?
While a student’s laptop and office software may qualify, not all computers and software are qualified expenses. Equipment and software that are primarily related to games, hobbies or sports would not be qualified. Also, books that are not required reading for enrolled courses are not qualified expenses. And smartphones and their service plans are not qualified expenses. Expenses incurred to play sports are not qualified expenses and insurance premiums are not qualified expenses. In addition, travel expenses are not qualified expenses for the purposes of 529 distributions.
Consider tax credits
In addition to determining which expenses qualify, you also want to consider taxes. To determine the amount to distribute from your 529 plan for this year’s college expenses, you want to evaluate which, if any, tax credit makes the most sense for you. The American Opportunity Credit (AOC) or the Lifetime Learning Credit may be available based on your income and the student’s enrollment status. As a general rule, you can’t double-dip on tax benefits. In other words, you can’t take a tax credit on money that you spent that was already tax-advantaged. Expenses paid with funds distributed from a 529 plan cannot be used to calculate the AOC or the Lifetime Learning Credit.
Also, the AOC is a use-it-or-lose-it credit. It can only be used for up to 4 tax years per student and only when the student has not completed his or her first 4 years of post-secondary education. In addition, this credit is refundable up to $1000. So, if you qualify for the credit you probably want to take the benefit while you can. You will want to keep it in mind when determining your 529 distributions.
Consult your advisor
It makes sense to plan for the appropriate distributions from 529 plans to ensure the most effective use of your college funding dollars. The combination of multiple funding sources, tax legislation, rules and regulations can be confusing. And, every situation is different. Consult your advisor to help you build a strategic plan to get the most out of your education savings.
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