529 Spending Rules for Tax-Free Withdrawals

A 529 plan is a state-sponsored investment account where earnings grow federally tax-deferred and withdrawals are tax-free when used for qualified education expenses. The Internal Revenue Service (IRS) dictates how these funds can be spent without incurring taxes or penalties.

Qualified Higher Education Expenses

A 529 plan’s purpose is to pay for qualified higher education expenses (QHEEs) at an eligible educational institution, which is any postsecondary school that can participate in federal student aid programs. QHEEs include tuition and fees required for enrollment or attendance.

Funds can be used for books, supplies, and equipment that are required for a course of study. The items must be mandated by the school or a specific course, such as a required textbook or lab safety goggles. This category is for items specifically needed for enrollment, not for general school supplies.

The cost of a computer, peripheral equipment like a printer, computer software, and internet access are also qualified expenses. These items must be used primarily by the beneficiary during any of the years they are enrolled at an eligible institution.

Room and board expenses qualify if the beneficiary is enrolled at least half-time. For students in on-campus housing, the qualified expense cannot exceed the school’s official cost of attendance figure for room and board. For students living off-campus, the allowance is limited to the amount the school sets for off-campus living in its cost of attendance data.

Plans can also cover expenses for a special needs beneficiary necessary for their enrollment, including specialized equipment. Additionally, costs for certain apprenticeship programs registered with the Secretary of Labor are qualified, including fees, books, supplies, and equipment.

Additional Qualified Expenses

Account owners can withdraw up to $10,000 per year, per beneficiary, for tuition at a public, private, or religious K-12 school. This limit is a per-student cap and applies only to tuition, not other school-related costs like fees or books.

A lifetime limit of $10,000 can be withdrawn from a 529 plan to pay the principal or interest on qualified education loans. This benefit extends to the beneficiary and their siblings, with each person having their own $10,000 lifetime limit. If you use tax-free 529 earnings to pay student loan interest, you cannot also claim the student loan interest deduction for that same amount.

Unused 529 funds can be rolled over into a Roth IRA for the beneficiary, subject to several conditions. The 529 account must have been open for more than 15 years. The rollover is subject to annual Roth IRA contribution limits and a lifetime maximum of $35,000 per beneficiary. Contributions made to the 529 plan within the last five years, and their earnings, are not eligible for the rollover.

Non-Qualified Withdrawals and Their Consequences

A withdrawal is considered non-qualified if the funds are used for anything other than a qualified education expense, which triggers tax consequences. Common examples of non-qualified expenses include:

• Transportation costs
• College application fees
• Health insurance
• Student loan payments that exceed the lifetime limit

For a non-qualified withdrawal, the earnings portion of the funds is subject to ordinary income tax at the recipient’s rate. The contributed amount, or basis, is returned tax-free. For instance, if an account is 30% earnings, then 30% of a non-qualified withdrawal would be taxable income.

The earnings portion of a non-qualified withdrawal is also subject to a 10% federal tax penalty, in addition to ordinary income tax. Some states may impose their own penalty on the earnings, and this combination of taxes and penalties can erode the account’s growth.

Taking a Distribution and Recordkeeping

Withdrawing funds from a 529 plan can be done in several ways. Payments can be made directly from the plan to the educational institution, to the account owner, or to the beneficiary. The recipient will receive IRS Form 1099-Q, which reports the gross distribution and the earnings portion.

The account owner is responsible for proving that withdrawals were used for qualified expenses. You must maintain detailed records, such as receipts and paid invoices, that link the amount and timing of each 529 withdrawal to a specific qualified expense.

You must coordinate 529 withdrawals with other education tax benefits. An expense paid with a tax-free 529 distribution cannot be used to claim another tax benefit, such as the American Opportunity Tax Credit (AOTC) or the Lifetime Learning Credit (LLC). For example, if you use a $5,000 withdrawal for tuition, you cannot use that same expense to calculate an AOTC, as this would be “double-dipping” on tax benefits.