A 529 plan allows you to set aside money to pay for a student's postsecondary education at an eligible institution. States and schools administer 529 plans that allow you to either prepay for education at a particular school or save money for use at any eligible institution in the U.S. or at selected foreign schools. Funds from a 529 plan used to pay for qualified expenses are not subject to federal income tax and may receive state tax benefits as well.
A 529 can be used to pay for expenses only at qualified educational institutions. The types of institutions eligible for 529 plans include:
- Vocational schools
- Other postsecondary education institutions
The institution must be eligible to participate in U.S. Department of Education student aid program. This encompasses nearly all U.S accredited postsecondary schools, whether public, non-profit or for-profit. Foreign schools that participate in the DOE's Federal Student Aid programs also can offer 529 plans.
Qualified expenses are a mix of costs imposed by the educational institution and expenses incurred by a student enrolled at least half time. These include:
- Supplies, books and equipment
- Expenses for special needs students arising from
enrolling or attending an eligible school
- Room and board
The room and board expenses are limited to the greater of two amounts:
- The institution's allowance for room and board included in the cost of attendance per academic period
- The actual amount paid by the student for
housing provided by the educational institution
The money you contribute to a 529 plan is not tax deductible. However, the earnings on your contributions are not taxed as long as you use the money to pay for qualified expenses. Any distributions in excess of the student's qualified expenses are taxable. You must subtract from qualified expenses any tax-free educational assistance, including:
- Tax-free scholarships, fellowships and Pell Grants
- Veterans' educational assistance
- Employer-provided assistance
Gifts and inheritances do not reduce qualified expenses. You may have to pay a 10 percent penalty on excess distributions from a 529 plan, although a number of loopholes exist.
Figuring the Tax
If a 529 plan distributes money in excess of qualified educational expenses, figure the tax by computing the ratio of qualified expenses to total distribution for the year, and multiply the total distribution by this ratio. Subtract the result from the total distribution to arrive at the taxable amount, and report it on IRS Form 1040. If you also must pay the 10 percent penalty, report it on IRS Form 5329. You can receive a federal tax credit from the American Opportunity Program or Lifetime Learning Program and still deduct 529 expenses as long they are not used to pay for costs covered by the federal tax credits.