This post is only relevant to people who are currently or anticipate paying for educational expenses, whether the expenses are for themselves or a family member.
First off, what is a 529? A 529 is an account used to pay for educational expenses. They come in two flavors: one that prepays tuition, and one that is invested in funds (or sometimes just a FDIC insured savings account) the same way that you invest 401k money in mutual funds.
I’m going to focus on the second type, but I’ll briefly go over the first type. Generally speaking, if you prepay tuition through a state’s 529 plan, those prepaid credits can only be used at that state’s schools. Because of this inflexibility, I wouldn’t recommend this plan to most people.
For the investment type 529s, from a federal tax standpoint they function in some ways like a Roth IRA for tax purposes: contributions are post tax, but withdrawals are not taxed so long as the withdrawal is used for educational expenses. But, if they are not used for educational purposes, then the gains are taxed as income, and assessed a 10% penalty.
For every 529, there is always a beneficiary and a custodian. The beneficiary is the one who is incurring or will incur educational expenses. The custodian is the one contributing money to the 529. The beneficiary and custodian can be the same person.
The tax loophole is not for federal taxes. It is for state taxes. Many states that offer an investment type 529 provide a state tax deduction for contributions (refer to this post if you are not familiar with what a tax deduction is). There is typically a limit on the tax deduction (though there are a couple states where it’s not). So for example, in my state, up to the first $2000 of my contribution to my state’s 529 plan is tax deductible.
Now here’s the interesting part. For most states that have the tax deduction for 529 contributions to their own plans, they let you deduction the contribution itself. It doesn’t have to be a net contribution for most states. So what I do is I contribute $2000, wait 10 days (the minimum waiting period required for my state’s plan), and pull out the money. Because I’m a grad student, I have educational expenses that I use this money for tax free. Hence, I’ve gotten a tax deduction of $2000, which at my state tax’s marginal rate of 6%, is worth $120 (0.06*2000 = 120). It seems ludicrous, because if I had just paid for my educational expenses directly, I would’ve gotten nothing. But just by funneling $2000 through a 529, I can save $120 on my state taxes.
Now what qualifies as an educational expense for 529 funds? Well, tuition and mandatory fees, of course. Which is the same as what qualifies as an educational expense for federal tax credits such as the American Opportunity Tax Credit and Lifetime Learning Credit. But, for 529 funds, there is also another expense that qualifies. room and board for students who are enrolled at least half time. From the IRS:
Expenses for room and board must be incurred by students who are enrolled at least half-time. The expense for room and board qualifies only to the extent that it is not more than the greater of the following two amounts.
- The allowance for room and board, as determined by the eligible educational institution, that was included in the cost of attendance (for federal financial aid purposes) for a particular academic period and living arrangement of the student.
- The actual amount charged if the student is residing in housing owned or operated by the eligible educational institution.
Notice how if the student lives off campus, the amount of money spent on room and board is irrelevant – only the cost of attendance estimates put out by the school matter.
So for example, the custodian of a 529 plan with the beneficiary as a graduate student at the University of Maryland (not my school) could withdraw $10808 during the 2014-2015 school year from a 529 plan and claim that money was used for room and board. There are no tax consequences for the custodian or the beneficiary even if the beneficiary’s actual expenses were lower than that. And, if the beneficiary lived on campus and incurred expenses more than $10808, the custodian could withdraw an amount of money equal to the actual expenses incurred.
Expenses covered by a 529 plan (called a QTP – qualified tuition plan in IRS publications) are not eligible for federal tax credits (which are generally worth more). Hence, 529 money should always be used for room and board expenses first.
In future posts I will discuss ways to save tax efficiently for college expenses (which include using 529 plans, among other things). But I think at least right now, my current readership will be better served by other topics, as they do not currently have kids that they want to send off to college some day.