4 Tips for Getting the Most Out of Your 529 Savings Plan

Two women walk to their college campus.
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The day you’ve been waiting for has finally arrived: You’re ready to use the money from your 529 college savings plan.

OK, so maybe it’s not exactly up there with “wedding” or “birth of a child,” but for those who’ve been contributing to a 529 plan over the years (or decades) to offset the costs of college, this is a big day.

Considering the average tuition, fees, and room and board charges for the 2019-20 school year at an in-state public university were $21,950, you’ll appreciate every dime you can put away ahead of time.

But before you break open that virtual piggy bank, you need to know which expenses are considered “qualified,” lest you get socked with federal and/or state income taxes and a 10% penalty.

Don’t worry — we have four tips to help you make the most out of your 529 funds — including one that could help out amid this pandemic-affected school year.

First, What Is a 529 Plan?

Quick primer: Sponsored by state governments or educational institutions, 529 plans are popular with parents and grandparents who want a dedicated college fund for their children or grandchildren.

Although each state sets lifetime contribution limits, the amounts are generally pretty high — starting at $200,000 or more, depending on the state.

By following the rules of your 529 plan — or “Qualified Tuition Program” as the Internal Revenue Service refers to it — you can maximize your savings by using tax-free growth and tax-sheltered withdrawals for many college education expenses.

So, here’s how to make your money stretch (not accounting for pizza in the dorm. That’s on you).

4 Ways to Get the Most Out of Your 529 Plan

Regardless of how much money you have in the account, you want to get the most bang for your 529 buck, right?

Over the years, updates and changes to the rules for 529 plans have made it easier to use the funds, but there are exceptions and caveats that could end up costing you. Check out these four tips to get the most value for your money.

1. If Your Parents Funded a 529, Use That First.

If your parents put money in a 529 savings account for you, using that money first to pay for your education can help you receive more financial aid later in your college career.

And it’s all thanks to your old friend, FAFSA.

That’s the Free Application for Federal Student Aid you should have filled out when you were applying to college (and every year during college). The FAFSA uses your Expected Family Contribution (EFC) to determine how much financial aid you qualify for, including free money from scholarships, grants and subsidized and unsubsidized student loans.

Pro Tip

Remember this formula: Cost of attendance - expected family contribution = financial aid award. The higher your EFC, the less financial aid money you’ll get. You can calculate your EFC here.

Your EFC is based on a number of factors, but one of the major ones is assets — 20% of a student’s assets get counted, but only 5.64% of parent assets are included. And if you’re a dependent, a 529 plan is considered a parent asset — even if it’s in your name.

So if your parents have a 529 for you with $20,000 saved in it, that counts as $1,128 toward your EFC. Compare that to if you had your own savings account with $20,000, which would count as $4,000 toward the EFC.

Using the 529 money earlier in your college career offers even more benefits, according to Billie Jo Weis, a client service manager with My College Planning Team.

“As you pull the funds out, your EFC is going to drop because next year when you report the value of that 529 plan, most likely it’s gone down,” she said.

So sticking with the same example, if you used $10,000 out of your 529 plan for your freshman year, the $10,000 left in your account would count for $564 toward your EFC when you fill out the FAFSA next year.

And because of the 529’s tax status, any funds your parents take out of the account to pay for college expenses are not reported as income on your FAFSA — which brings us to our next tip.

2. If Your Grandparents Funded a 529, Save It for the Final Year(s).

If you have a 529 funded by grandparents (or another generous relative besides your parents), the FAFSA doesn’t count that money as an asset. Yay!

But as soon as you use the account, the FAFSA counts that money as your income. Boo.

If you have multiple 529 accounts owned by parents and other relatives, it can get a bit confusing, Weis noted.

“It’s an inverse relationship,” she said. “So when the parent owns it, it’s recorded as an asset but is not considered income at the time, but with a grandparent, it’s not considered an asset but it is reported as income.”

This is an important distinction — and could be a costly one if you don’t hold onto your non-parent funds until the end of your college career.

“You have to be very careful with the timing of when the grandparents are going to use that 529 money to pay the school,” Weis said. “If they pay the school too soon and too much, it’s going to be considered student income.”

Pro Tip

If you plan to go to a college that requires the CSS Profile, Grandma’s 529 account will likely count as an asset. Before applying for financial aid, ask the school what their policy is on 529 plans. 

Student income is counted at 50%, so if Gram paid $10,000 out of her 529 plan for your freshman year, it will count as $5,000 of ordinary income. Ouch.

Waiting until your last FAFSA to use those 529 funds is key, according to Weis, since the prior-prior year’s tax return is used for determining your income. We’ll explain.

Say you’re starting college this year. If you used $15,000 from Gram’s 529 funds to pay for the fall semester of the 2020-21 school year, the money will be reported as ordinary income on your next year’s FAFSA.

When you fill out the FAFSA for your junior year (2022-23), you’ll use your 2020 tax return to determine your EFC. (That’s right — the FAFSA looks back two years.) So that $15,000 withdrawal will be counted as $7,500 in student income on your junior year FAFSA, reducing your financial aid eligibility.

So what’s the solution for using Gram’s 529?

“It’s safest just to wait until that last FAFSA is filled out,” Weis said. “And you really want to make sure you’re in your junior year,” adding that if you discover you’re a few credit hours short or need to add another year to your college plan, you could get an unwelcome surprise of a smaller financial aid award for your final year.

And even if holding onto the funds an extra year means you have to take out a student loan during your freshman or sophomore year, you can now use up to $10,000 from your 529 savings account to repay student loans, thanks to the Setting Every Community Up for Retirement Enhancement Act of 2019 (although check with your state to ensure it considers student loan repayment a qualified distribution).

Weis also noted that dependent students receive an income protection allowance of $6,840, which covers both income earned from a job and money from a non-parental 529 account  (Federal Work-Study income is exempt).

So if your grandma used $5,000 from the fund to pay for tuition and you earned from $1,800 from an off-campus job that year, you could exclude the entire amount from your EFC (because you earned less than $6,840). But if Gram used $8,000, then $2,960 would count as your income.

If you plan to work even a part-time job while in school, it’s probably safer to ask your relative to wait to use the 529.

FROM THE DEBT FORUM

3. If You’re Not Living on Campus, You Can Use Your 529 for Groceries and Rent (Probably).

Whether it’s by your choice or due to a campus closure, your plans to live in the dorm this year could be altered. You can still use your 529 for qualified room and board expenses… probably.

During a normal year, “room and board” is typically the price of your dorm room and a meal plan — amounts that are set by your college. Whatever the college posts as the price is the amount you can take out of your 529 for the cost of living (confirm that amount with your financial aid office each year). But there are specific restrictions you need to know about living expenses.

First, there’s a rule about using 529 funds for room and board that don’t apply to tuition, books and fees: You have to be working toward a degree and attending school at least half-time.

So if you’re using this year to cut back on classes and work instead, there’s a good chance you can’t use your 529 funds to pay for rent and food.

Pro Tip

Computers, printers and internet access are all considered qualified expenses that you can use your 529 funds to buy.

Second, the school dictates what the cost of living is, which limits what you can spend from your 529.

There are a lot of rules about what’s considered “room.” Your parents’ house, for example, is an asset in their name.  So you can “rent” a room from your parents (think of it as a taste of the post-graduation real world), but your share has to be reasonable and the 529 withdrawal can’t exceed the cost of tuition, room and board. In other words, Weis said, you can’t just have a free-for-all and use the entire 529 to pay your parents’ mortgage.

And if your brain is already concocting schemes to get around that, know the IRS has probably already thought of them.

If you transfer the title to your name so you pay the mortgage, for instance, that makes the house your asset, increasing your contribution to the EFC.

And if your parents want to charge you rent (which you could then use 529 funds for up to your college’s published cost of room and board), they’ll have to claim your payments as rental income on their tax returns — again, increasing the EFC.

Either way, you’re not going to save bundles by avoiding taxes.

But if you are living at home, you could use 529 funds to pay for your groceries since you’re not eating meals on campus — just make sure you’re only buying food (not shampoo and hand sanitizer). Keep your receipts for your grocery runs — you’ll need them come tax time.

If you’re renting an apartment off campus, you could also potentially use your 529 to pay rent and utilities, but the total has to be less than your college’s cost of attendance.

4. It’s Not a Use-It-or-Lose-It Fund.

If it turns out you have leftover money in your 529 and you fear losing it forever, it may be tempting to go on a shopping spree at the campus bookstore or treat your entire floor to pizza.

Yeah, don’t do that.

Your 529 account is yours forever, and there’s plenty you can do with the money after graduation, including the following:

Pay for grad school.

You’re so ready for that cap and gown — you don’t even want to think about more school. But if there’s any chance you’ll want to pursue an advanced degree, your 529 could help pay for grad school.

Transfer it to a family member.

Return the favor to your family. Your parents can roll over your 529 funds to your siblings, your grandparents can change the beneficiary to another grandchild or the account owners could use the money for their own college or trade school education.

Pro Tip

Scholarships are an exception to the 10% penalty — you can withdraw an amount equal to the scholarship from your 529 account — but you’ll still have to pay taxes on any earnings.

And even if kids seem like a distant future possibility, you can hold onto your 529 for your own child’s education (depending on your state, K-12 private school tuition may also be a qualified distribution).

Hold onto it as an emergency fund.

If your economic situation catastrophically changes at some point and you’re in a desperate situation — think: you’re going to become homeless or you won’t be able to put food on the table — remember that the money in a 529 plan is yours.

Yes, you’ll pay taxes and a penalty on a non-qualified withdrawal, but the cost may be worth it to keep you and your family safe.

Tiffany Wendeln Connors is a staff writer/editor at The Penny Hoarder. Read her bio and other work here, then catch her on Twitter @TiffanyWendeln.