How Do You Use 529 Funds to Pay for College?

A 529 plan is a tax-advantaged savings vehicle designed to help families pay for educational costs. To ensure withdrawals remain free from federal taxes, the funds must be used for qualified expenses and follow specific distribution and reporting rules.

Identifying Qualified Expenses

To maintain the tax-free status of a 529 plan withdrawal, funds must be used for Qualified Higher Education Expenses (QHEE). The primary qualified expense is tuition and fees for enrollment at an eligible educational institution, which includes most colleges, universities, and vocational schools.

In addition to higher education, up to $10,000 per year can be withdrawn tax-free for tuition at an elementary or secondary public, private, or religious school. Funds can also cover costs for registered apprenticeship programs, including fees, books, supplies, and equipment.

Beyond tuition, funds can cover books, supplies, and equipment required for a student’s coursework. For example, the cost of a specific textbook listed on a course syllabus or mandatory lab coats for a science class are considered QHEEs.

Room and board expenses also qualify, but with limitations. For students in college-owned housing, the qualified amount is the actual charge. For students living off-campus, the allowance is capped at the figure the college includes in its official cost of attendance, which can be found through the school’s financial aid office.

The purchase of a computer, peripheral equipment, software, and internet access are QHEEs, provided they are used primarily by the beneficiary while enrolled. Unlike other expenses, these do not need to be required by the school, but items not used for education, like gaming consoles, do not qualify. Common costs that are not QHEEs include transportation to campus and student health insurance fees, though up to a $10,000 lifetime limit can be used for student loan repayments.

The Distribution Process

Once a qualified expense is identified, you can request a distribution from the 529 plan. Most administrators offer withdrawals through an online portal or by submitting a physical request form via mail.

There are three options for where the funds can be sent. The payment can be made directly to the educational institution, which simplifies record-keeping for large bills like tuition. Another option is to pay the expense out-of-pocket and then request a reimbursement to the account owner.

A third option is to have the payment sent directly to the student beneficiary to cover ongoing expenses like books or off-campus rent. Regardless of the method, you should retain all receipts and invoices for qualified expenses to prove the withdrawals were used appropriately in case of an IRS audit.

The timing of the distribution is important. To remain tax-free, the withdrawal must occur in the same calendar year that the qualified expense was paid. For example, if you pay for spring semester tuition in December, the 529 withdrawal must also be made before the end of that year.

Tax Reporting and Coordination

After taking a distribution, the plan administrator will issue Form 1099-Q to the recipient by January 31 of the following year. This form details the withdrawals, breaking them down into the gross distribution (Box 1), the earnings portion (Box 2), and the contribution basis (Box 3).

If total distributions are less than or equal to the beneficiary’s adjusted qualified higher education expenses (AQHEE), the earnings are not taxable income and do not need to be reported on your tax return. AQHEE is calculated by taking total QHEEs and subtracting any tax-free aid the student received, such as scholarships.

You must coordinate 529 withdrawals with federal education tax credits like the American Opportunity Tax Credit (AOTC) and the Lifetime Learning Credit (LLC). The IRS prohibits using the same expense to justify both a tax-free 529 withdrawal and an education tax credit.

To maximize tax savings, families should strategically allocate expenses. For example, a family could pay for the first $4,000 of tuition with non-529 funds to claim the full AOTC. The 529 plan can then be used for remaining tuition, room and board, and other qualified expenses.

Handling Non-Qualified Withdrawals

A withdrawal not used for a qualified expense is a non-qualified distribution. This can happen by withdrawing more than the amount of adjusted qualified expenses for the year. The consequences apply only to the earnings portion of the withdrawal.

The earnings portion of a non-qualified withdrawal is subject to ordinary income tax plus a 10% federal penalty. The part of the withdrawal that represents your original contributions is returned tax- and penalty-free. For example, if a $10,000 non-qualified withdrawal includes $2,000 of earnings, only that $2,000 is subject to income tax and the $200 penalty.

In some situations, the 10% penalty is waived, though income tax on earnings still applies. These include the beneficiary receiving a tax-free scholarship, attending a U.S. military academy, or in the event of the beneficiary’s death or disability.

If you accidentally make a non-qualified withdrawal, you can avoid the tax and penalty by re-contributing the funds to any 529 plan for the same beneficiary within 60 days. This 60-day rollover rule provides a safety net for account owners.

Funds no longer needed for education can be rolled over tax-free to a Roth IRA for the beneficiary, subject to several conditions:

• The 529 account must have been open for at least 15 years.
• Contributions made in the last five years are not eligible to be moved.
• The amount rolled over cannot exceed the annual Roth IRA contribution limit and the beneficiary must have earned income at least equal to the rollover amount.
• A lifetime maximum of $35,000 can be transferred per beneficiary.