After years of saving, years of working hard in high school and a well-deserved graduation ceremony, it’s finally time to go to college. Due to lots of careful planning, you are ready and can afford all your educational expenses because your 529 has been growing steadily over the years. But now that the time has come to use it, how do you access the money? You’ve grown accustomed to putting money in, but now, when and how much can you take out and for what uses, to avoid any taxes and penalties?
What is a 529 Plan
A 529 plan is a tax advantaged saving plan designed specifically for educational expenses. You invest money into this account and choose how you want your money to grow; aggressively with stocks or more conservatively with bonds or maybe a mix of both. Over the years, your money can grow exponentially if you are consistently adding to it, and reinvesting your earnings each year. If you use the money for “qualified” educational expenses, you can withdraw it, without any financial penalties or federal taxes.
Most states offer 529 plans, but you don’t have to open one from your state, you are free to open one anywhere. However, depending on where you live, there may be more tax benefits to enjoy by contributing to an in-state plan, such as a deduction on your state taxes up to a certain contribution amount. That said, 529 plans can also have fees and an out-of-state plan might have a better fee structure that outweighs your in-state tax benefits, so be sure to look at all aspects of all the plans you are considering to find the one that is the most financially advantageous for you.
What is a “Qualified Educational Expense”
There are certain criteria that will determine what a qualified educational expense is. For example, just because an institution calls itself a “school” doesn’t mean paying tuition there will qualify. That said, most community colleges, 4-year colleges and universities will qualify, if they are accredited.
With the rise of interest in trade schools, some might be wondering if trade school tuition is a qualified educational expanse. The answer is yes and no; while you can use 529 money for vocational or trade school, not all trade schools are eligible. For the trade school to be eligible, they need to participate in the federal student aid program led by the U.S. Department of Education.
Other eligible expenses, in addition to tuition, are room and board (on-campus housing or off-campus housing up to the housing cost included in the school’s total cost of attendance), books and supplies, fees, computers, software and other necessary technology required for enrollment. Outside of the classroom, some professional credentialing fees like exam costs and licensing fees may also be eligible as a qualified education expense. Since not all credential fees will qualify, be sure to confirm with your tax professional before withdrawing the money to ensure you will not be penalized for doing so.
Some expenses that not included are transportation costs, insurance such as health insurance premiums (even if offered by the school) and extracurricular activities such as expenses related to joining or participating in clubs, sports or other activities not directly related to your coursework. Again, it’s always best to call your 529 plan administrator, school financial aid office or tax professional to verify eligibility for an expense.
If you withdraw money for a non-qualified educational expense, you will incur a 10% penalty in addition to income tax on the amount withdrawn, so be mindful, save your receipts and any other relevant documentation to avoid any issues.
Withdrawing 529 Funds
To withdraw funds from your 529 account, start by logging in to your account online or contacting your plan administrator. Look for the option to request a withdrawal or distribution. You will need to decide where the funds should go. You can choose to send the payment directly to the school, to yourself as the account owner for reimbursement, or to the student (i.e. the beneficiary) for their expenses. Once you’ve determined the recipient, specify the amount you wish to withdraw, and make sure it matches the qualified expense you are using it for to avoid penalties.
To finish, complete the withdrawal request form, which can typically be done online or via mail, depending on your plan’s process. Be prepared to provide any necessary documentation, such as a billing statement from the school or proof of expenses. It’s important to keep records of all receipts, invoices, and withdrawal confirmations in case the IRS questions the withdrawal.
Reporting Withdrawals to the IRS
You don’t generally need to report 529 withdrawals on your taxes if they were used for qualified educational expenses. These withdrawals are tax-free, as long as the funds are used for eligible costs such as tuition, fees, room and board (if the student is enrolled at least half-time), books, supplies, and other required educational expenses.
However, it’s important to keep detailed records, including receipts and invoices, to prove that the withdrawal was used for qualified expenses in case the IRS requests documentation. If any portion of the withdrawal was used for non-qualified expenses, the earnings portion of that amount would need to be reported on your tax return, as it may be subject to income tax and a 10% penalty.
In the Event of an Audit
If you're audited and you've used funds from your 529 account, the key is to stay calm and organized. Start by gathering all receipts, invoices, and records of the qualified educational expenses you paid for with the 529 funds. This includes tuition bills, room and board expenses (if applicable), textbook and supply receipts, and technology expenses like computers, software, or internet access if required for education. You will also need to collect your 529 withdrawal statements from your plan provider to show the amounts withdrawn and where the funds were sent, whether directly to the school, to you, or to the beneficiary.
Be sure that the amount withdrawn matches the qualified expenses incurred in the same calendar year, as the IRS will want to confirm that the funds were used appropriately and within the correct timeframe. If the funds were used for tuition or other school-related costs, provide proof of the student’s enrollment, such as a letter of enrollment, a class schedule, or a tuition statement from the school. If the IRS requests information, respond promptly by the deadline provided in the audit notice and include all relevant documentation to support your case.
If the audit becomes complex or you’re unsure how to proceed, consider consulting a tax professional or CPA who can help you navigate the process and ensure compliance with IRS requirements. To avoid issues in the future, always keep detailed records of your 529 withdrawals and the expenses they cover, and make sure to withdraw funds in the same calendar year as the expenses to prevent nonqualified withdrawals. By staying organized and providing clear documentation, you can demonstrate that your 529 withdrawals were used appropriately and resolve the audit efficiently.