Today’s lesson: 529 plans and you

Times Staff Writer

Your 18-year-old is on the way to college, and you’re tapping into that stash of money you’ve accumulated over the years in one of those tax-free college savings plans. ¶ But if you want to pay for more than room, board, tuition and books, you’d better check with the federal revenooers first. Buy the wrong thing and you could be hit with taxes and a 10% penalty on your earnings. ¶ Want to use the money to buy a laptop computer for the kid? Maybe you can, maybe not. Want to pay off part of a student loan taken the year before? Forget about it. Got enough for a down payment on a used car so college boy can come home once in a while? You’ve got to be kidding. Even transportation at school isn’t covered.

Since 1996, Section 529 of the Internal Revenue Code has allowed parents, grandparents and others to set aside money in special state-sponsored savings plans for a child’s “qualified higher education expenses.” A major attraction, of course, is that all the interest earned can be spent tax free -- as long as it’s on qualified expenses.

So what are qualified expenses? The code defines them as “tuition, fees, books, supplies, and equipment required for the enrollment or attendance” at school. Pretty black-and-white, for the most part. But needs change every year, and the law stays the same.

What constitutes “supplies” and what “equipment” is “required for the enrollment or attendance” at school?


“One of the questions we get asked the most is, ‘Can I use the money to buy a laptop?’ ” said Joe Hurley, founder of, one of the top Internet sites for information about tax-free savings plans.

Using 529 funds to buy a laptop is one of the squishiest of issues and one ripe for congressional action.

For now, the answer depends on whether a class or the school itself requires students to have computers. An architecture student who has to use modeling software might be able to justify spending 529 money to buy a laptop. But a business major? Probably not.

James Carlin wasn’t going to take any chances. For the last two years, the Manhattan Beach resident has been pulling money out of a college account for his son, Jeffrey, a business and accounting major at Cal Poly San Luis Obispo.

Even before his son graduated from high school, though, Carlin had decided that he wasn’t about to test the law by using the funds to purchase a computer. Luckily for Jeffrey, he got a laptop as a graduation gift.

“The lion’s share of the funds goes for tuition, books and room and board,” said Carlin, a partner at the Santa Monica accounting firm Holthouse, Carlin & Van Trigt. He expects that Jeffrey will drain the account on those kinds of expenses.

Where it becomes a bit dicier, however, is figuring out qualified 529 expenses while living off campus and buying your own food and such school supplies as notebooks, pens and paper.

The room and board expense, for instance, can’t be greater than what the school specifies as its room and board costs -- typically what is charged for on-campus housing and meal plans.

And then there’s the problem of managing receipts, especially for out-of-pocket expenses. After all, when the IRS comes calling, you need the receipts to justify withdrawals from the fund.

“I do my best to keep track of things,” Jeffrey Carlin said. “But there have been times when I’ve run into a market quickly to grab a few things and didn’t keep the receipts.”

The 529 industry is booming. The number of plans rose nearly fivefold since 2001 and the total value of funds shot up tenfold to $130 billion, according to trade group College Savings Plans Network. The organization, which represents state governments, universities and financial companies, expects an additional $70 billion to $100 billion to flow into 529 plans over the next five years.

Each state and the District of Columbia sponsor at least one 529 plan and use investment houses or management firms to administer them. California has two categories with a number of plans operated by Fidelity Investments.

Some states -- but not California -- offer deductions on state income taxes for contributions to 529 plans, and the industry is pushing Congress to adopt the idea for federal income tax laws.

Anyone can set up an account with just about any state fund and use the money at nearly any public or private school nationwide -- even at many foreign universities.

“These funds are mainly geared for typical college expenses,” said Kevin McMullen, chairman of the nonprofit College Savings Foundation, a clearinghouse for 529 plans, the most popular type of college savings account.

Qualified expenses

Still, the industry built up to promote 529 plans wants a few changes.

The College Savings Plans Network, which lobbies for 529 plan administrators and state education officials, is asking Congress for an amendment to include computers, Internet access and educational software as specified qualified expenses.

“Just about every student feels it’s required for attendance,” said Hurley, who has two children in college and has set up accounts under 32 different state plans for comparison.

But if a computer or software isn’t required, you’d better dig into your own pocket to buy one for your son or daughter. Spending 529 funds on the purchase would subject you to taxes plus the penalty on the interest earned.

Also excluded as qualified expenses are insurance premiums, sports or club activity fees, repayment of student loans and, for those living off campus, room and board costs that exceed the amount the school defines as its “cost of attendance” for federal financial aid purposes.

It may be a different matter, though, if the school or a class requires such expenditures.

“Some school programs involve complete supplies, lab fees and travel expenses,” said Eva Rosenberg of TaxAnxiety Inc., a Northridge firm that operates the tax information website “You can have the 529 administrator pay directly to the school. Then there are no worries at all.”

A forestry student, for instance, might be able to justify spending 529 money on a hatchet or shovel for classes that might take him or her into a forest, but not for a truck to get there, said Internal Revenue Service spokesman Victor Omelczenko.

There are no court rulings on what expenses are eligible, say legal and tax experts. But the IRS acknowledges that regulations are out of date, and it is working on proposals to bring to Congress.

One of the problems is that another section of the Internal Revenue Code that governs what are known as Coverdell plans allows savings to be used for the purchase of computers and related equipment. But the plans are more restrictive in many other areas, making them far less popular than 529 accounts.

“There probably are a lot of people getting away with things, unless they’re audited,” said Mark Luscombe, principal federal tax analyst at publishing house CCH Inc. “It’s up to those who are audited to justify the expenses.”

The gray areas of the law may not matter to many folks. College Savings Plans said the average size of 529 accounts at the end of December 2007 was $12,316.

Tuition, fees, books and room and board at nearly all colleges could wipe that out in a year or two, experts point out.

Still, the plans have soared both in value and in the number of accounts opened, according to College Savings Plans. The number of accounts has tripled in five years to nearly 10.6 million, with nearly 207,000 in California. The total value of funds has rocketed fivefold to nearly $130 billion.

When it comes to spending the money, Hurley has found little difference among the 32 state funds in which he has invested. “It’s a pretty short list of qualified expenses,” he said.

Tips for careful spending

Nevertheless, there are pitfalls to be aware of in pulling money out of 529 plans.

* Don’t take too much money out. If you withdraw more than your child incurs in qualified expenses, you’ll end up paying taxes and penalties on the extra interest earned.

* Don’t take too little money out. Basically, you want to spend it all on your child’s schooling, though you can designate another child, a spouse or even yourself as a beneficiary for future school expenses.

* Don’t take money out in December for a bill that isn’t paid until January. You risk not having enough qualified expenses to cover that December withdrawal.

* Determine whether withdrawals should go to you or directly to the school. Sending it to the school ensures that withdrawals are matched with expenses and draws less attention from the IRS. But schools can mix up fund money with loans, grants and financial aid your child may have. That could cause problems with your child’s financial aid package. You should make sure the school recognizes that the money is coming in from a 529 plan and that it should not affect other financial aid.

* Keep good records. You don’t have to match every withdrawal to a specific expense, but your total withdrawals for the year cannot exceed your qualified expenses. If they do, you’ll end up paying taxes and penalties on earnings.

IRS rules don’t make it easy to work with 529 plans, and calls to simplify matters often go unanswered. As TaxMama’s Rosenberg admitted: “As angry as I get with the IRS at times, they are required to enforce the laws as they’re written.”

Carlin is glad he has the 529 account for his son so he doesn’t have to pay for college out of his current salary.

“If he goes to graduate school, it could be a different story,” Carlin said.



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Online resources

Here are some websites with information and advice on 529 college savings plans: