Figuring Out the Qualifying Criteria for a 529

Section 529 plans seem to be wrapped in qualification after qualification, but don't allow these endless lists of criteria discourage you from using 529 plans. Instead, check out this breakdown of qualifications so that you can easily identify whether your plan, your student, and your student's expenses meet the myriad criteria associated with 529 plans.

Making sure your plan qualifies

In order for a Section 529 plan to qualify under the IRS's rules, it must meet the following criteria:

• Contributions may be made only in cash, including checks, money orders, or payroll deductions, but not in stocks, bonds, or real estate.

• After a contribution is made into a specific plan, you may not direct the investments. You may, however, change plans once each year.

• You may not pledge the value of the account as security against any sort of loan.

• The plan or program in which you invest must provide each designated beneficiary a separate accounting.

• You can't contribute more into an account, or group of accounts, for the benefit of a single designated beneficiary than the beneficiary will use in the payment of qualified higher education expenses. You have to try to estimate this amount.

When you make a contribution to a Section 529 plan, you're not allowed any federal income tax deduction for the amount of your contribution. Depending on what state you live in, you may get a current state income tax deduction for part or all of your contribution each year.

After your money is safely tied up in a Section 529 plan, interest that you earn on it isn't taxed until distributions (amounts of money you take out of the plan to pay your student's expenses) are made to your designated beneficiary. And, if you use distributions from these plans to pay the qualified education expenses of a student at an eligible educational institution, accrued earnings generally aren't taxed at all.

In other words, a Section 529 plan allows you to save for college, and it exempts or defers income tax on the accrued earnings until the designated beneficiary begins taking distributions from the plan.

Making sure your student qualifies

Strangely enough, the things you think of when the phrase "qualified student" comes to mind (grades, commitment, drive, and so on) have absolutely nothing to do with the IRS's definition. For the purpose of Section 529 plans, a qualified student must meet the following criteria:

• He or she needs to be the original designated beneficiary of the plan or, in the case of a tax-free plan rollover to another beneficiary, must be a member of the same family as the original beneficiary in one of these listed relationships:

• Spouse

• Child, grandchild, or great-grandchild

• Stepchild, stepmother, or stepfather (but no stepgrandchildren)

• Brother, sister, stepbrother, or stepsister

• Father, mother, or grandparents

• Niece or nephew

• Brother or sister of your mother or father

• First cousin

• An in-law, either mother, father, sister, brother, son, or daughter

• Husband or wife of any person on this list

• He or she must actually be an enrolled student at a qualified educational institution.

Making sure expenses qualify

Parents who fund Section 529 plans need to be very conscious of what constitutes a qualified higher education expense and what doesn't. (Trips to Cancun, unless part of your child's specific university program, and a sports car won't make the grade.)

Distributions from 529 plans that pay for nonqualifying expenses will qualify for income tax on the earnings portion (not on the amount of your contribution into the plan). Your student will also pay an additional 10 percent tax on the income, otherwise known as a penalty, unless she qualifies for an exception.

All eligible schools are now required to provide you with not only the price of what you will pay them directly (tuition, fees, and often room and board) but also the total cost of what they expect an academic year to cost. This is called the budget, or the total cost of attendance, and includes tuition, fees, room and board, books, supplies, insurance, transportation, and miscellaneous items. Remember, even though the total budget amount may be higher, only the expenses in Table 1 are qualified for payment from a Section 529 plan.

Table 1: Qualified Higher Education Expenses for 529 Plans

Qualified expense limitations

The amount of qualified expenses you may be able to use Section 529 plan distributions to pay for are limited if you fall into any of these categories:

• If your qualifying student receives tax-free educational assistance (outright grants and scholarships), the amount of expenses that would otherwise qualify will be reduced by the amount of the tax-free aid.

• If your qualifying student is also the beneficiary of a Coverdell Education Savings Account and receives distributions from that plan, all qualified expenses need to be divided proportionately between the two plans. You can't double dip, or take the full amount of qualifying expenses from each plan.

• If you want to take the Hope and/or Lifetime Learning Credits on your income tax return, you need to use taxable income to pay for at least a portion of your student's qualifying expenses.

Exceptions to tax-free distribution rules

Beginning in 2002 and currently scheduled to end after December 31, 2010 (the "sunset provision"), distributions made from Section 529 plans for payment of qualifying educational expenses are free from federal income tax (state income tax rules may differ — check with your state). The federal government has found an effective way to provide incentives for you to send your children to college; however, it has also built in many safeguards to make certain that you don't abuse its kindness.

When taxable distributions do occur, the federal income tax is paid by the designated beneficiary, not by the contributor(s) to the plan (rules regarding state income tax vary by state). Often, the rules aren't clear, even to the IRS, or your situation may be ambiguous. Don't hesitate to seek advice.