Readers have a lot of questions about “529” college-savings plans.

After we published an article recently about these education-savings accounts, readers swamped us with questions—about how to withdraw funds for college, the impact on financial aid and more. (The plans can also be used for some K-12 tuition, but we focus mainly on the college use.)


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Here are answers to some of the most-common questions we received.

It is almost time for my beneficiary to start college. What do I need to know about making withdrawals? 

First, make sure you’ll be using the money for qualified expenses, such as tuition, room and board, books and supplies, and computers. Expenses that don’t qualify include things like transportation, campus parking, cellphones, club fees or dues, or furnishing a dorm room, according to the College Savings Plans Network, a repository for 529 plan data. 

A withdrawal can be requested several ways: online, by paper form or call center. The money can be sent directly as payment to the institution, or to the account owner or beneficiary as a reimbursement, says Rachel Biar, assistant state treasurer in Nebraska and vice chair of College Savings Plans Network.

For tuition and on-campus room and board, the easiest thing to do is request that 529 money be sent directly to the college or university. But account owners can request reimbursements for eligible out-of-pocket expenses—say for the purchase of books or a computer—that they or the beneficiary incur.

The account owner has the responsibility to keep all purchase receipts for tax purposes. Plans won’t ask to see verification that you’re using the funds for a qualified expense, but the IRS might. Owners will want the receipts in case of a tax audit, Ms. Biar says. 

Another important tax issue: It is essential to take a distribution within the same calendar year that you incurred the expense, says Indiana State Treasurer Kelly Mitchell.

If you pay out-of-pocket for a covered expense in October 2021 but don’t remember to reimburse yourself until February 2022, that distribution would be considered a nonqualified expense, she says. There could be state and federal tax consequences, and some plans may impose fees or penalties.

I own a 529 plan with my granddaughter as the beneficiary. What impact will the 529 have on her eligibility for financial aid? Would it be better if I just give her $10,000?

Gifts to a grandchild and distributions from a 529 owned by a grandparent both can reduce the amount of need-based financial aid a student receives, says Mark Kantrowitz, a college-planning and financial-aid expert. Each counts as income for the student.

However, as the rules now stand, starting on Jan. 1 of your granddaughter’s sophomore year, you can give her a cash gift or use a 529 distribution to pay qualified expenses for her and it won’t have an effect on her future eligibility for aid. Cash gifts and distributions are reportable as untaxed income for the grandchild on the Free Application for Federal Student Aid, or Fafsa. But the Fafsa requires that you report the student’s income from two years earlier; so the soonest your Fafsa application could reflect that income would be two years later. Assuming she graduates in four years, there is no impact on aid eligibility, Mr. Kantrowitz says.

Another option, he says, could be to do a rollover from a grandparent-owned 529 plan to a parent-owned 529 plan after the Fafsa is filed. The parent then uses a qualified distribution to pay college costs. This way, on the Fafsa, there’s no concern about the grandparent-owned funds affecting the student’s financial aid, Mr. Kantrowitz explains. One caveat is that the parent-owned 529 should be in the same state as the grandparent-owned 529. “This will avoid recapture of state tax breaks, since many states treat a rollover to an out-of-state 529 plan as a nonqualified distribution,” he says.

In the future, these workarounds might be unnecessary. Fafsa simplification is being phased in and, as part of that effort, a question pertaining to cash support is likely to be eliminated. This is where the untaxed income from these gifts and 529 distributions are reported, Mr. Kantrowitz says. 

The simplification was originally supposed to go into effect with the 2023-24 Fafsa, which will be based on 2021 income. Recently, however, the Education Department said it would need additional time to fully implement the measures. This would mean the change affecting grandparents would be postponed until at least the 2024-25 Fafsa, which will use income from 2022, Mr. Kantrowitz says.

Can 529 funds be used to pay loans?

The Setting Every Community Up for Retirement Enhancement Act of 2019, also known as the Secure Act, permits some 529 funds to be used for qualified education loan repayment. This includes all federal and many private loans. A lifetime maximum of $10,000 in qualified student-loan repayments can be withdrawn for a beneficiary and $10,000 for each of the beneficiary’s siblings. This limit cannot be bypassed by having multiple plans for a beneficiary, Mr. Kantrowitz says. You’ll also need to be aware of how your federal-student-loan interest deduction will be reduced.

Parents who have federal Plus loans can also pay them down using 529 funds, subject to the same limits. To do this, the parent who holds the loan would need to be named the account beneficiary, instead of the student. A beneficiary can be changed at any time to another member of the beneficiary’s family. 

There could also be state-tax implications to using 529 funds to repay education loans, so check your plan’s program description, also known as a plan disclosure statement or disclosure booklet, before heading down this path.

Can I change the beneficiary to a nonfamily member?

You can open a 529 account for a beneficiary who is not related to you as long as the person is a U.S. citizen or resident alien with a Social Security number or federal tax identification number.

However, if you change the beneficiary after opening the account, the new beneficiary should be a family member, says Michael Frerichs, Illinois state treasurer and chair of the College Savings Plans Network. 

A change to a nonfamily member would be treated as a nonqualified distribution, which could mean federal and state income taxes, as well as a 10% penalty on account earnings. That said, there is a broad definition of who qualifies as a family member, including children, siblings, parents, nieces, nephews, children-in-law, spouses and first cousins, he says.

What happens to the 529 funds if the account owner dies?

Generally speaking, when you open an account, you have an option to name a successor owner, which is always a good idea, Mr. Frerichs says. If there is no successor owner, your plan’s program description will detail what contingencies might apply and what actions, if any, need to be taken.

“We encourage people to name a successor owner; that is the easiest thing,” he says. But even if they don’t, “people shouldn’t be worried that it’s going to revert to the state and the beneficiary won’t have any access,” he says.

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The Team at Davis Financial Group
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