November 3, 2020
Basic information about tax-free educational savings
Section 529 of the federal tax code makes it possible for you to save money for your child’s education, tax-free. Legally known as “qualified tuition plans,” a 529 plan is a tax-advantaged savings plan designed to encourage saving for future education costs.
There are two types of 529 plans:
Prepaid tuition plans
- units or credits at participating colleges / universities are paid for your child
- these are usually public and in-state colleges / universities
- units / credits are for future tuition & mandatory fees at current prices
- units / credits usually cannot be used to pay for future room & board
- a variety of stipulations apply and funds may or may not be guaranteed by the state
Education savings plans
- an investment account is opened to save for your child’s qualified education expenses
With both plans if you use the withdrawals for qualified educational expenses, they are generally tax-free.
And expect to pay enrollment/applications fees, as well as some sort of administrative or management fees (and possibly more) for both types of plans.
What are considered as qualified education expenses?
For education savings plans, typically they’re talking about tuition, mandatory fees, as well as room and board. Plan withdrawals can generally be used at any college or university and, in some cases, even at non-US colleges and universities. Your savings can also cover up to $10,000 per year per beneficiary at any public, private or religious elementary or secondary school.
Make a plan for spending 529 funds.
While you can make a withdrawal from the account for any reason, if you spend the funds on non-qualified expenses, you’ll have to pay federal income taxes. Also, you’ll incur a withdrawal penalty on the portion of the withdrawal that comes from the investment earnings in the account.
If your child earns a scholarship, you can take a non-qualified withdrawal up to the amount of the scholarship. You won’t have to pay any penalties, but you will have to pay a penalty on the investment earnings.
Qualified expenses include:
- Required fees
- On-campus housing
- Off-campus housing up to the college’s housing allowance
- On-campus meal plans
- School-related special services
Some financial planners suggest that the plan pay the school directly, while others recommend that you withdraw the funds and pay the school yourself. Regardless of which option you choose, strict record keeping is highly recommended. If you get audited, you want to be sure everything the IRS reviews is clean.
No matter what you do, for investment advice concerning 529 plans, speak with your licensed investment advisor to choose the most appropriate plan for your child and your family’s unique situation.
The information in this article is intended to be general in nature and not serve as financial advice. Fuller information can be found on the U.S. Securities and Exchange Commission’s website, SEC.gov.
Robert Baer is a Vice President at Fidelity Bank. He coordinates Fidelity’s Financial Literacy initiative.