Should I Use 529 Money First for College Expenses?
Learn how to strategically use 529 plan funds for college expenses while considering tax benefits, withdrawal timing, and coordination with other financial aid.
Paying for college is a major financial decision, and using 529 plan funds wisely can make a big difference. These accounts offer tax advantages, but deciding when to use the money requires careful planning.
One key question is whether to spend 529 savings early or reserve them for later expenses. The right choice depends on financial aid, tax benefits, and avoiding penalties.
Eligible Education Costs
Not all college expenses qualify for tax-free 529 withdrawals. The IRS defines eligible costs as those required for enrollment or attendance at an accredited institution. Tuition and fees are the largest expenses, but mandatory charges like lab fees and technology costs also qualify.
Room and board are covered if the student is enrolled at least half-time. However, withdrawals for housing and meals cannot exceed the school’s published cost of attendance. If the student lives off-campus, rent and groceries can be paid with 529 funds, but only up to the school’s official allowance.
Books, supplies, and equipment necessary for coursework are also eligible. This includes textbooks, lab materials, and software required for classes. Computers and internet access qualify if primarily used for schoolwork, but entertainment-related electronics, like gaming consoles, do not.
Penalties for Misuse
Using 529 funds for non-qualified expenses leads to financial penalties. The IRS imposes a 10% penalty on earnings from non-qualified withdrawals, and the earnings portion is taxed as ordinary income.
There are exceptions. If the beneficiary receives a tax-free scholarship, attends a U.S. military academy, or becomes disabled, withdrawals up to the amount of the scholarship or benefit can be taken without the 10% penalty. However, the earnings portion remains taxable.
Misusing funds can also create state tax issues. Many states offer tax deductions or credits for 529 contributions, but if funds are withdrawn for non-qualified expenses, some states require taxpayers to repay those benefits.
Balancing With Scholarships and Grants
Coordinating 529 withdrawals with financial aid helps maximize benefits. Scholarships and grants reduce out-of-pocket costs but also affect how much 529 money should be withdrawn. If a student receives significant aid, it may seem logical to save 529 funds for later, but failing to use them efficiently could leave money unused or subject to penalties.
To avoid excess withdrawals, families should compare 529 distributions with remaining qualified expenses after financial aid is applied. Since scholarships typically cover tuition first, 529 funds may be better used for housing, books, and required equipment. Reviewing billing statements helps determine which costs remain unpaid.
If a student receives a scholarship that offsets tuition, an equivalent amount can be withdrawn from a 529 plan without the 10% penalty, though the earnings portion is still taxed. In some cases, keeping the money invested for future costs, such as graduate school or student loan repayment, may be a better option.
Timing of Withdrawals
Withdrawals must match qualified expenses incurred in the same tax year to avoid penalties. Taking money out in December for a bill due in January could create tax complications. Tracking tuition payments, housing costs, and other educational expenses ensures withdrawals align correctly.
The timing of withdrawals also affects financial aid. Distributions from a parent-owned 529 plan are considered a parental asset and assessed at a maximum of 5.64% under the FAFSA formula. However, if a grandparent or other relative owns the account, withdrawals count as untaxed student income, which can reduce aid eligibility by up to 50% of the withdrawn amount. Delaying distributions from non-parental accounts until after the student’s final FAFSA filing year can help avoid this issue.
Tax Implications of Fund Usage
Using 529 funds efficiently requires understanding tax rules. Withdrawals for eligible education expenses remain tax-free, but any portion exceeding those costs is taxed as ordinary income.
If a student receives a refund from their school due to dropping a class or overpayment, the IRS allows the funds to be recontributed to the 529 plan within 60 days to avoid penalties. Additionally, up to $10,000 in 529 funds can be used for student loan repayment, providing another tax-advantaged option for excess funds.