by Susan Quilty

Created on: August 04, 2009

Tax-advantaged 529 plans are designed to encourage saving toward college expenses. However, withdrawals from 529 plans must be used for eligible college expenses. If they are not, the funds are subject to penalty fees and taxes.

Eligible college expenses may vary depending on the specific 529 plan. When setting up a 529 plan, find out which college expenses will be allowed. The

College Savings Plan Network provides links to most 529 plans by state. In general, eligible college expenses include tuition, books, required equipment for class, mandatory fees, and supplies.

If a student is enrolled half-time or more, room and board may also be considered an eligible college expense. The allowable amount for eligible room and board will vary based on the costs set by the specific college. For special needs students, additional equipment needed to attend college may be allowed as well.

Earnings on a 529 plan that are not used for eligible college expenses may be subject to federal income tax at the rate of the owner of the plan (generally the parent). They are subject to state and local income taxes as well. In addition, a 10% penalty fee is assessed on any earnings that are not used for eligible college expenses.

There are a few situations that will minimize the penalties. If a student has earned a full scholarship and therefore does not need the 529 plan for college expenses, the earnings will be taxed at the student's income tax rate and the 10% penalty fee is waived. The 10% penalty fee is also waived in the case of death or disability of the beneficiary (student).

In the case of scholarships, remember that even full scholarships may not cover incidentals which could qualify as eligible college expenses under the 529 plan. As 529 plans are designed for higher education, they can also be kept and used for graduate school at a later date.

Additionally, 529 plans can be switched to another beneficiary, such as a sibling. There are no fees or tax implications to switching beneficiaries. Some 529 plans do limit how often you can switch beneficiaries, such as once per year. This is helpful particularly for leftover funds that can be switched to a younger child instead of being cashed out with taxes and penalties.

Saving for college is an important goal and 529 plans can help parents (or grandparents) reach that goal. Understanding the tax penalties for unused portions of the 529 plan is important, as is knowing which college expenses are allowable under the chosen 529 plan.

Penalties fees and taxes are in place to stop abuse of 529 plans by those who would use the plans as a tax shelter with no intention of paying for college. These penalties should not keep parents and students who are saving for college from reaping the benefits of these tax-advantaged plans.

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