Basics of Section 529 Plans: Figuring Out the Qualifying Criteria (page 2)
Section 529 plans seem to be wrapped in qualification after qualification, but don't allow these endless lists of criteria discourage you from using 529 plans. Instead, check out how I break down those lists of qualifications so that you can easily identify whether your plan, your student, and your student's expenses meet the myriad criteria associated with 529 plans.
When you make a contribution to a Section 529 plan, you're not allowed any federal income tax deduction for the amount of your contribution (unlike many sorts of retirement plans, which defer income tax not only on the accrued earnings in the account but also on your contributions). Depending on what state you live in (and if you use its plan), you may get a current state income tax deduction for part or all of your contribution each year.
After your money is safely tied up in a Section 529 plan, interest that you earn on it isn't taxed until distributions (amounts of money you take out of the plan to pay your student's expenses) are made to your designated beneficiary. And, if you use distributions from these plans to pay the qualified education expenses of a student at an eligible educational institution (these are the IRS's words, not mine), accrued earnings generally aren't taxed at all.
In other words, a Section 529 plan allows you to save for college, and it exempts or defers income tax on the accrued earnings until the designated beneficiary begins taking distributions from the plan.
At this point, you may be thinking that the only educational institutions that these plans are qualified to pay for are colleges and universities. Not true. Qualified institutions include all postsecondary schools that are eligible to participate in U.S. Department of Education financial aid programs, including many vocational and technical schools, community colleges, and even some apprenticeship programs. Eligible institutions don't need to be located in the United States; many foreign colleges and universities qualify. The standard here is that the schools must be eligible; they don't actually have to participate in these financial aid programs. Check with the institutions you or your student are interested in to be sure that they qualify.
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:
- 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").
|Type of Fee||Full-Time Student at an Eligible Institution||Part-Time Student at an Eligible Institution|
|Room and board (paid directly to educational institutions)||Yes||If enrolled half time or more, yes; otherwise, no|
|Room and board (paid directly to other landlord and grocery store)||Yes, to extent allowed by budget amount set by school||If enrolled half time or more, yes, to extent allowed by budget amount set by school; otherwise, no|
|Fees (as required by the institution)||Yes||Yes|
Books, supplies, and equipment
*Computers are accorded special treatment effective 2009-2010. All other school supplies must be required by the school to be eligible.
|Yes, to extent allowed by budget amount set by school||Yes, to extent allowed by budget amount set by school|
|Expenses of a special-needs beneficiary necessary for enrollment at an eligible institution||Yes (regulations defining qualifying expenses are still pending)||Yes (regulations defining qualifying expenses are still pending)|
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.
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