Guide to 529 College Savings Plans for Federal Employees

For many federal employees who are the parents of high school seniors, May was college decision month. May 1st was the actual deadline for high-school seniors to pick a college or university to attend starting in fall 2023.

For parents of these high-school seniors who through the years have contributed to 529 college savings plans, this should prompt the parents (or grandparents who may have contributed to the 529 college savings plan on behalf of their grandchildren) to plan withdrawals from these 529 plans.

The 529 college savings plans were started nearly 40 years ago and are one of the best tax-efficient ways to set aside money for a child’s or a grandchild’s post-secondary education. Named after the Internal Revenue Code Section authorizing them, 529 accounts allow savers to make contributions that can be invested and grow federal and state income tax free.

There are no federal tax breaks on contributions. Some states offer tax breaks on contributions in the form of state income deductions or state tax credits. Withdrawals from 529 accounts, and this includes both contributions and accrued earnings, are income tax-free if used to pay qualified education expenses. Contributions were already taxed but accrued earnings have grown tax-deferred and withdrawn income tax-free if used to pay qualified education expenses for the designated 529 account beneficiary.

Besides using 529 account withdrawals to pay for college or university qualified education expenses, the Tax Cuts and Jobs Act of 2017 allows withdrawals from 529 accounts to pay for kindergarten through grade 12 tuition and fees at private and parochial schools.

The remainder of the column presents key points of 529 college savings plans.

Eligible Post-Secondary Schools

Virtually all accredited US colleges and universities which are able to participate in federal student-aid programs can receive tax-free distributions from 529 accounts to pay qualified expenses. Distributions from 529 accounts can also be used at many trade schools, such as culinary training.

About 400 post-secondary schools outside the US are eligible to receive 529 distributions. If a parent is unsure whether or not a post-secondary learning institution accepts 529 funds, they should ask the institution whether the institution qualifies for 529 plan distributions.

Qualified Expenses

529 college savings plan distributions are tax-free provided they are used to pay for qualified expenses. Qualified expenses include tuition, fees, books, room and board, and computers and software used by the student.

As noted, 529 plan withdrawals can pay for room and board. However, to use 529 distributions to pay for a student’s room and board at a college or university, the student must be enrolled in the institution at least half-time. Students living and eating off campus can use 529 withdrawals to pay for rent and grocery bills, up to limits that are similar to the school’s charges for room and board. But 529 funds typically cannot be used to pay transportation costs.

It should be noted that changes to the 529 college savings plans in recent years have expanded what counts as a “qualified 529 expense”. As previously noted, the Tax Cuts and Jobs Act of 2017 allowed 529 plans to pay K-12 tuition at private and parochial schools. SECURE Act 1.0 (passed into law in December 2019) allows a 529 plan to pay up to $10,000 of 529 plan beneficiary’s student loan debt as well as an additional $10,000 for the student loans of each of the beneficiary’s siblings. SECURE Act 1.0 also expanded expenses to include qualified apprenticeship programs, thus allowing 529 plan distributions for textbooks, fees and equipment related directly to these job training programs.

Making Payments and Saving Receipts

There are two ways in which a 529 college savings plan owner can pay the qualified expenses of the 529 plan beneficiary. One way is for the plan owner or the beneficiary to pay the qualified expenses and then submit a form to the 529 plan administrator for reimbursement. In that case, the plan owner or beneficiary should be sure to keep all receipts from any paid qualified expense. By saving the receipts, the plan owner or beneficiary can prove that he or she spent what was claimed for reimbursement.

Also, by saving the receipts the plan owner or beneficiary will have the documentation needed to justify the claim. These receipts do not need to be submitted with the plan owner’s tax return. But the receipts will be needed in case of an IRS audit.

The other way for the 529 plan owner or beneficiary to pay the qualified expense is to have the 529 plan directly send the 529 plan distribution to the college, university, trade school, etc. Sending it directly is a straightforward way to avoid a potential misstep. A 529 plan provider has withdrawal forms that distribute funds in this manner.

Another important suggestion when withdrawing funds from a 529 plan: The 529 plan owner should spend 529 funds in the same calendar (tax) year in the year the funds are withdrawn. With a fall semester and a spring semester, a school year spans two calendar (tax) years.

Meanwhile, a tax year occurs within one calendar year. That “mismatch” can inadvertently cause a tax headache. Therefore, a 529 plan owner should plan to spend the withdrawn funds from the 529 plan in their entirety during that same calendar year. It is important for 529 plan owners to keep a log of exactly how much they take out of the plan each year and how much was actually spent. This way the plan owner can make sure all money is spent within the calendar year.

IRS Reporting of 529 Plan Distributions

Any distributions made from a 529 college savings plan are reported to the IRS by the 529 plan administrator on Form 1099-Q (Payments from Qualified Education Programs). The plan also sends a copy of Form 1099-Q to the 529 plan owner or the beneficiary. A sample 1099-Q is presented below.

Note that Box 1 on 1099-Q (“Gross distributions”) represents the distributions (consisting of the 529 plan contributions and earnings) made during the year to the 529 plan owner during the year on behalf of the 529 plan beneficiary. Box 2 on Form 1099-Q (“Earnings”) are the earnings portion of the gross distributions (which are not taxable provided they are used to pay qualified expenses). Box 3 on Form 1099-Q (“Basis”) is the 529 plan contribution portion of the gross distributions and is not taxable because 529 plan contributions are always made with after-taxed dollars.

Individuals do not have to report 529 plan distributions on their federal and state income tax returns provided they are not taxable. But if a 529 plan distribution during any year is larger than total eligible expenses, then income tax plus a 10 percent penalty is due on the earnings and not the principal (basis).

The following example illustrates:

Paul withdraws $40,000 from a 529 college savings plan he funded for his daughter Harriet’s college costs. The withdrawal consists of $20,000 of contributions (principal) and $20,000 of earnings. However, Harriet incurs only $35,000 of qualified expenses. In that case, income tax and a 10 percent penalty tax will be owed on $20,000/$40,000 times $5,000 ($40,000 less $35,000), or 50 percent of $5,000, which is $2,500. The $2,500 represents the earnings portion of the excess payout and subject to income tax and a 10 percent ($250) penalty.

There are some exceptions to the 10 percent penalty including when the 529 plan beneficiary receives scholarships that help pay for qualified expenses. Those beneficiaries/students who receive refunds of previous paid 529 expenses (for example, students who left campus during the COVID pandemic) can sometimes re-contribute the refunded 529 account distribution to a 529 account within 60 days and avoid paying the taxes and the penalty.

Transfers of 529 Accounts

A 529 college savings plan owner can switch the beneficiary on an account without any tax consequences if the switch in beneficiary is to a family member. Family members include spouses, siblings and first cousins.

529 plan owners can also leave account to others at death.

529 College Savings Plan Rollovers at Death

A provision of SECURE Act 2.0 allows rollovers of 529 funds into Roth IRAs. In particular, the provision will allow 529 beneficiaries to transfer up to $35,000 (of unused 529 funds) from a 529 college savings plan to the beneficiary’s Roth IRA. Among other requirements, the 529 plan must have been open for at least 15 years.

The change will allow 529 college savings plan beneficiaries with excess funds in their 529 accounts to rollover the excess funds to a Roth IRA for the purpose of boosting their own retirement savings.

The opportunity to rollover excess 529 funds to Roth IRAs does not take effect until January 1, 2024. The IRS will be providing full guidance on these rollovers, most likely starting in fall 2023.

SEE ALSO: IRS FAQs on 529 college savings plans.