Do you have children in grades K-12 who are enrolled in a private school? Is your child flying the nest this fall to pursue a post-secondary education? If so, you may be eager to tap into the 529 Plan you have been funding for years. However, before making any distributions, consider the following questions.
What is the benefit of a 529 Plan?
Contributions to a 529 Plan grow tax-free so long as the funds are ultimately distributed to pay for the plan beneficiary’s qualified education expenses. Prior to 2018, this tax incentive was only available if the plan was used to fund the beneficiary’s post-secondary education. Under the Tax Cuts and Jobs Act of 2017, 529 Plans can now also be used to cover up to $10,000 of a child’s K-12 tuition.
It is important to note, however, that some states have not updated their laws to include K-12 tuition as an eligible 529 Plan expense. To avoid potentially significant negative tax consequences, be sure to discuss your state’s laws with your qualified tax professional prior to using your 529 Plan for this purpose.
What post-secondary education expenses can be covered by a 529 Plan?
While K-12 qualified education expenses are limited to tuition only, the rules for post-secondary qualified education expenses are more expansive. Qualified post-secondary education expenses include:
- Tuition and fees;
- Supplies (including computers and computer supplies); and
- Room and board, limited to the greater of:
- The allowance for room and board included in the school’s cost of attendance for federal financial aid calculations; or
- The actual amount charged if the student is living in housing operated by the educational institution.
Save your receipts! It may be helpful to separate these qualified purchases from other non-qualified purchases by running separate transactions at the checkout register.
How might a scholarship or other tax-free tuition assistance affect the use of 529 Plan funds?
Tax-free educational assistance, such as a Pell Grant, tax-free scholarship, tuition discount, or tax-free employer educational assistance program, reduces the amount payable from a 529 Plan. For example, if the cost of one semester of classes is $10,000, and the plan beneficiary receives a tax-free scholarship for $8,000, only the remaining $2,000 is eligible to be paid using the 529 Plan.
How do 529 Plans relate to the American Opportunity Tax Credit and Lifetime Learning Credit?
These tax credits can be extremely valuable. The American Opportunity Tax Credit (AOTC), for example, provides a tax credit of 100% of the first $2,000 of eligible expenses and 25% of the next $2,000 of eligible expenses for a total credit of $2,500. The Lifetime Learning Credit (LLC) provides a tax credit of 20% of the first $10,000 of eligible expenses for a total credit of $2,000. However, in order to be eligible for these credits, the eligible expenses used to claim the credit cannot be paid using 529 Plan funds. For example, if the beneficiary of a 529 Plan is eligible for the AOTC, it may be a good idea to leave $4,000 of qualified education expenses unpaid by the 529 Plan. This will allow the taxpayer to claim the full $2,500 AOTC.
Be aware that the AOTC begins to phase out once your modified adjusted gross income (MAGI) reaches a certain level. If your MAGI will prevent you from claiming the AOTC, you may choose to pay the qualified education expenses fully from your 529 Plan.
Do I need to designate the source of funds (e.g., 529 Plan funds, scholarship awards, out-of-pocket cash, etc.) used to pay different education expenses?
If you plan to use a 529 Plan to cover qualified post-secondary education expenses and also anticipate eligibility for the AOTC or LLC, be careful about which expenses are paid with 529 Plan funds. Room and board, for example, is not considered a qualified education expense for purposes of the AOTC or LLC. Therefore, if you plan to leave $4,000 of education expenses unpaid by the 529 Plan in order to claim the AOTC, be sure the $4,000 of expenses is not for room and board.
There are many important factors to consider before using a 529 Plan to pay for education expenses. The information listed above is not intended to be an exhaustive review of these factors. Before dipping into your 529 Plan, consult with your Stifel Financial Advisor and qualified tax professional to be sure you are well positioned to achieve the best results.Investors should consider carefully the investment objectives, risks, and charges and expenses associated with a 529 Plan before investing or sending money. The official program offering statement, which includes information on municipal fund securities, is available from your Financial Advisor and should be read carefully before investing. The value of a 529 account may fluctuate, and there is no guarantee that any investment portfolio will achieve the stated goal. Your investment may be worth more or less than its original value.
Non-qualified withdrawals are taxable as ordinary income to the extent of earnings and may also be subject to a 10% federal income tax penalty. State tax treatment may differ. Investors should discuss their particular tax situation with a tax professional.