Basics of Section 529 Plans: Figuring Out the Qualifying Criteria

Making Sure Your Plan Qualifies

In order for a Section 529 plan to qualify under the IRS's rules, it must meet the following criteria:

• Contributions may be made only in cash, including checks, money orders, or payroll deductions, but not in stocks, bonds, or real estate.
• After a contribution is made into a specific plan, you may not direct the investments. You may, however, change plans once each year.
• You may not pledge the value of the account as security against any sort of loan.
• The plan or program in which you invest must provide each designated beneficiary a separate accounting.
• You can't contribute more into an account, or group of accounts, for the benefit of a single designated beneficiary than the beneficiary will use in the payment of qualified higher education expenses. You have to try to estimate this amount.

Making Sure Your Student Qualifies

Strangely enough, the things you think of when the phrase "qualified student" comes to mind (grades, commitment, drive, and so on) have absolutely nothing to do with the IRS's definition. For the purpose of Section 529 plans, a qualified student must meet the following criteria:

• He or she needs to be the original designated beneficiary of the plan or, in the case of a tax-free plan rollover to another beneficiary, must be a member of the same family as the original beneficiary in one of these listed relationships:
• Spouse
• Child, grandchild, or great-grandchild (a lineal descendent)
• Stepchild, stepmother, or stepfather (but no stepgrandchildren)
• Brother, sister, stepbrother, or stepsister
• Father, mother, or grandparents (a lineal ancestor)
• Niece or nephew
• Brother or sister of your mother or father
• First cousin
• An in-law, either mother, father, sister, brother, son, or daughter
• Husband or wife of any person on this list
• He or she must actually be an enrolled student at a qualified educational institution.

Making Sure Expenses Qualify

When I went to college, a fancy car, a nice apartment, and spring breaks in exotic locations were part of the package for many of my classmates. (My package included public transportation, shoe leather, university housing, and vacations in lovely downtown Baltimore " watching traffic going to the Orioles games was very exciting!) Of course, this was before the days of any qualified tuition plans, let alone Section 529 plans, so the question of what was a qualified expense and what wasn't never entered the discussion. It was more a question of what your parents could afford and were willing to spend.

Things have changed a little in the intervening years. Now, although all the extra perks are still the norm for many students, parents (and other relatives) who fund Section 529 plans need to be very conscious of what constitutes a qualified higher education expense and what doesn't. (Trips to Cancun, unless part of your child's specific university program, and a sports car won't make the grade.) Table 5-1 lists qualifying higher education expenses.

Distributions from 529 plans that pay for nonqualifying expenses will qualify for income tax on the earnings portion (not on the amount of your contribution into the plan). Your student will also pay an additional 10 percent tax on the income, otherwise known as a penalty, unless she qualifies for an exception (see the section "Exceptions to tax-free distribution rules").

Table 5-1:  Qualified Higher Education Expenses for 529 Plans

All eligible schools are now required to provide you not only with the price of what you will pay them directly (tuition, fees, and often room and board) but also the total cost of what they expect an academic year to cost. This is called the budget, or the total cost of attendance, and includes tuition, fees, room and board, books, supplies, insurance, transportation, and miscellaneous items. Remember, even though the total budget amount may be higher, only the expenses in Table 5-1 are qualified for payment from a Section 529 plan.

Qualified Expense Limitations

The amount of qualified expenses you may be able to use Section 529 plan distributions to pay for are limited if you fall into any of these categories:

• If your qualifying student receives tax-free educational assistance (outright grants and scholarships), the amount of expenses that would otherwise qualify will be reduced by the amount of the tax-free aid.
• If your qualifying student is also the beneficiary of a Coverdell Education Savings Account and receives distributions from that plan, all qualified expenses need to be divided proportionately between the two plans. You can't double dip, or take the full amount of qualifying expenses from each plan.
• If you want to take the Hope and/or Lifetime Learning Credits on your income tax return, you need to use taxable income to pay for at least a portion of your student's qualifying expenses.

Exceptions To Tax-Free Distribution Rules

Beginning in 2002 and currently scheduled to end after December 31, 2010 (the "sunset provision"), distributions made from Section 529 plans for payment of qualifying educational expenses are free from federal income tax (state income tax rules may differ " check with your state). The federal government has found an effective way to provide incentives for you to send your children to college; however, it has also built in many safeguards to make certain that you don't abuse its kindness.

When taxable distributions do occur, the federal income tax is paid by the designated beneficiary, not by the contributor(s) to the plan (rules regarding state income tax vary by state). Often, the rules aren't clear, even to the IRS, or your situation may be ambiguous. Don't hesitate to seek advice here.

The following are instances where the designated beneficiary may be required to pay a federal income tax on distributions from a Section 529 plan:

• Using plan distributions to pay nonqualifying expenses: If the designated beneficiary takes a distribution but doesn't use it to pay qualified expenses, he or she is basically out of luck. The accrued earnings on that distribution will be taxed at normal income tax rates, plus an additional 10 percent for trying to pull the wool over the government's eyes. The news here is not all bad, though; if only a part of the distribution is used to pay nonqualified expenses, the entire distribution isn't tainted. Only the earnings on the portion that didn't pay qualified expenses will be taxed.
• Terminating a plan, because the designated beneficiary chose not to continue his or her education or because some money is still left in the plan after completing that education: When a plan is terminated (rather than rolled over into another plan or beneficiary), the earned income that's distributed, whether to the designated beneficiary or the plan owner, along with the original contribution amounts is taxable. In addition, it's subject to the 10 percent additional penalty. Likewise, if the plan contains more cash than the designated beneficiary will use for qualified higher education expenses, the income portion of that excess distribution is taxable, and the 10 percent additional tax applies.
• Taking plan distributions from an institutional plan before January 1, 2004: If you set up a plan with a specific college or university or a consortium of colleges and your designated beneficiary begins to take distributions before January 1, 2004, for qualified expenses, he or she will have to pay the income tax on the accrued earnings, but not the additional 10 percent. Unfortunately, the tax-exempt distribution rules for institutionally administered plans don't come into play until January 1, 2004; fortunately, because institutional plans only came into being in concept in 2002 and in actuality in 2003, not too many people should be affected.
• Distributing funds on account of the death of the designated beneficiary: If you need to distribute funds to a beneficiary's estate or to someone other than the designated beneficiary of the plan, due to the death of that beneficiary, the earned income portion of the distribution is taxable; however, no additional 10 percent tax is assessed.
• Making distributions due to the long-term disability or impending death of the designated beneficiary: In much the same way as insurance companies can now prepay life insurance policies to terminally ill patients without any adverse tax consequences, the IRS now allows distributions from Section 529 plans to be made to terminally ill beneficiaries and to beneficiaries with a long-term and indefinite disability. The earned income portion of these distributions is taxable, but no 10 percent additional tax is assessed. You do need to provide the IRS with a doctor's note to qualify for this exemption.
• Using the Hope or Lifetime Learning Credits: To the extent that you use certain qualified educational expenses to qualify for the Hope and Lifetime Learning Credits, those expenses will no longer qualify for tax-free treatment, even if you paid for them from your Section 529. The earnings portion will be taxed, with no additional 10 percent tax; again, no double dipping is allowed.
• Receiving education benefits that are excludable from gross income: If you're fortunate enough to receive qualified scholarships, veteran's assistance, funds from employer tuition-reimbursement plans, or other tax-free benefits (excluding gifts, bequests, or inheritances), the earnings on Section 529 plan distributions are taxable only if the amount of the 529 plan distribution is less than or equal to the amount of other tax-free educational assistance. There is no 10 percent additional tax. For example, if your student's qualified expenses equal $20,000, he receives a $20,000 tax-free scholarship, and you make a $20,000 distribution to him from his Section 529 plan, he will pay income tax on the earnings portion of the 529 plan distribution, but no penalty, even though none of the distribution is being used to pay qualified educational expenses. From the IRS's standpoint, it's enough that it would have been used for that purpose if your student hadn't received the scholarship.