Your guide to 529 college savings plan withdrawals

Share this article

Each fall, many of our clients’ children and grandchildren begin their college experience. As we guide these families from the accumulation phase through the use of their college savings, we’ve found that it has been helpful to review the features of 529 College Savings Plans and offer reminders on how to take advantage of these benefits. Of course, each family’s circumstances are unique and we welcome the opportunity to discuss your specific situation.

529 College Savings Plans (“529 plans”)

529 plans are state-sponsored investment accounts that offer tax advantages to parents and grandparents saving for college. Each account has an “owner” (typically the parent or grandparent) and a “beneficiary” (the student). Investments within a 529 plan grow tax-free and withdrawals for qualified college costs can be withdrawn free of federal income tax.

Additionally, many states offer state tax benefits for contributions (Illinois provides a state tax deduction¹ for investments made to an Illinois-sponsored plan) and most states exempt qualified withdrawals from state taxation (Illinois exempts qualified withdrawals from any state’s sponsored plan)².

Common questions as students prepare for the fall semester

What expenses are considered "qualified" for the purposes of tax-free 529 withdrawals?

Qualified expenses include:

  • Tuition and fees paid directly to the school

  • Books, supplies and required equipment. Textbooks must be on the required reading list.

  • Computers and peripheral equipment, software and internet access, as long as they’re used primarily by the student. Computer software must be educational in nature.

  • Room and board, as long as the student is enrolled half time or greater. 100% of on-campus housing expenses are considered qualified, while students living in off-campus housing are limited to the amounts published by the school’s “Cost of Attendance” figures. This information is generally available via the school’s website.

  • Up to $10,000 per year for tuition at K-12 private schools. Check with your accountant first though!  Some states, including Illinois, have not yet amended their state tax code to allow for this type of withdrawal.

These withdrawals are considered qualified if they are used for certain expenses incurred by attending a school that meets the required higher education or post-secondary training criteria. Eligible schools include those with a “Federal School Code” for the purposes of federal student aid.

Expenses that are not considered qualified include:

  • Travel and transportation costs

  • Insurance

  • Repayment of student loans

  • Sports expenses or health club dues

  • Equipment used for amusement and/or entertainment

When must funds be withdrawn to be considered “qualified”?

To qualify for tax benefits, 529 withdrawals must be made in the same calendar year (not academic year) as the year the payment was received for the education expense. It is important to consider the time frame necessary for processing, as a withdrawal made during the year must be used for an expense paid prior to year-end. For example, a withdrawal processed in December for an expense paid in January of the following year would not be considered qualified for tax purposes.

What is the impact of a non-qualified withdrawal?

Withdrawals that are not used for qualified expenses may be subject to federal and state income taxes. In most cases, the “earnings” portion of the withdrawal will be taxable as ordinary income and subject to a 10% federal income tax penalty. Additionally, non-qualified withdrawals may be subject to state taxes and the recovery of a state tax deduction filed for in previous years (for Illinois taxpayers, the earnings portion of a non-qualified withdrawal is subject to state income taxes and the recovery of past deductions taken for contributions to an Illinois-sponsored plan).

The 10% federal income tax penalty does not apply to withdrawals due to death or disability of the beneficiary, or for the portion of the distribution equal to or less than any scholarships received.

Non-qualified withdrawals paid to the account owner are subject to the owner’s marginal income tax rate, while distributions paid to the beneficiary are subject to the beneficiary’s marginal rate. Keep in mind that any non-qualified withdrawals will be considered for the calculation of any “kiddie tax” due on unearned income.

How can I keep good records?

While the 529 account provider will provide an annual statement detailing the allocation between the account’s “basis” (contributions) and “earnings,” it’s the responsibility of the account owner to maintain records documenting the student’s expenses and withdrawals.

Account owners should keep all receipts for educational expenses and segregate the qualified expenses from non-qualified costs. Additionally, many 529 accounts allow for payments to be made directly to the school. This may simplify the documentation and recordkeeping.

What if anything is left over?

In the event that a 529 account has a balance at the conclusion of the student’s college term, an account owner has a number of options:

  • The account can remain invested for the student’s graduate school or other post-secondary education.

  • The account owner can change the account beneficiary to another family member at any time. This change can be used to transfer the account balance for a sibling’s or cousin’s use.

  • The account owner can also transfer the ownership of the 529 to another family member (including the previous account beneficiary). This will allow the new account owner to name another family member as a beneficiary – in some cases, the account can be maintained for the original beneficiary’s children’s educations!

  • Withdrawals can be paid to the account owner or beneficiary, though distributions that are not used for qualified expenses will be subject to income taxes and penalties.

As parents and grandparents ourselves, it’s often bittersweet to see our clients’ children go off to college. But it is satisfying to know that all our planning for this event is now coming to fruition. Please don’t hesitate to reach out to your wealth advisor with any additional questions or concerns you may have about college funding as you begin this exciting next step in your child’s or grandchild’s life. 

1 Illinois limits the annual state tax deduction to $10,000 for single taxpayers and $20,000 for married taxpayers filing joint returns.

https://www.savingforcollege.com/compare_529_plans/?plan_question_ids%5B%5D=437&page=compare_plan_questions

Before investing in an "out-of-state" 529 college savings plan review the potential other benefits that may be provided by investing in a 529 college savings plan offered by the home state of the investor or of the designated beneficiary. Those benefits may include financial aid, scholarship funds, and protection from creditors.

Connect with an advisor

Mesirow does not provide legal or tax advice. Past performance is not indicative of future results. The views expressed above are as of the date given, may change as market or other conditions change, and may differ from views express by other Mesirow associates. This is not a solicitation to buy or sell the securities mentioned. Do not use this information as the sole basis for investment decisions, it is not intended as advice designed to meet the particular needs of an individual investor. Information herein has been obtained from sources which Mesirow believes to be reliable, we do not guarantee its accuracy and such information may be incomplete and/or condensed. All opinions and estimates included herein are subject to change without notice. This communication may contain privileged and/or confidential information. It is intended solely for the use of the addressee. If you are not the intended recipient, you are strictly prohibited from disclosing, copying, distributing or using any of the information. If you receive this communication in error, please contact the sender immediately and destroy the material in its entirety, whether electronic or hard copy. This material is for informational purposes only and is not intended as an offer or solicitation with respect to the purchase or sale of any security.

Mesirow refers to Mesirow Financial Holdings, Inc. and its divisions, subsidiaries and affiliates. The Mesirow name and logo are registered service marks of Mesirow Financial Holdings, Inc. ©2021, Mesirow Financial Holdings, Inc. All rights reserved. Any opinions expressed are subject to change without notice. Past performance is not indicative of future results. Advisory Fees are described in Mesirow Financial Investment Management, Inc.’s Form ADV Part 2A. Advisory services offered through Mesirow Financial Investment Management, Inc. an SEC registered investment advisor. Securities offered by Mesirow Financial, Inc. member FINRA and SIPC.