Two types of 529 plans allow account-holders to invest money in a plan for future college expenses, with tax advantages. The 529 plan variations are the prepaid tuition plan, which allows for the purchase of units or credits for tuition and fees at locked-in rates at qualifying schools; and the college savings plan, an investment account to build funds for college costs. In each plan, an account-holder opens and controls the account, which will help pay for the education of a designated beneficiary.
Prepaid tuition plans and college savings plans both allow account-holders to withdraw funds for qualified college expenses without incurring any federal income taxes on the earnings. Plans vary on the mechanics of the withdrawals. Some require that funds be withdrawn directly to the college, ensuring that they go to college expenses. Others allow the account-holders to withdraw the money to make the payments, but those plans sometimes require receipts as proof of the college costs.
Prepaid tuition plans and college savings plans differ on the qualified expenses that withdrawals can be used for. Prepaid tuition plans have a much narrower set of eligible expenses: only tuition and mandatory fees. Some plans let account-holders also purchase an option for room-and-board expenses or to use excess funds for other costs, according to the Securities and Exchange Commission. College savings plans let account-holders use the money not only on tuition and mandatory fees, but for room and board and necessary expenses, such as books and computer equipment.
There are tax consequences if money is withdrawn for purposes other than qualified college expenses. Account-holders can determine whether they'll have tax liabilities by comparing the amount of money withdrawn from a 529 plan in a tax year to the adjusted qualified education expenses. That is calculated by subtracting any tax-free educational assistance that a beneficiary received from the total qualified educational expenses. If the amount withdrawn exceeds those expenses, then the account-holder or the beneficiary -- depending on who received the funds -- must pay federal income taxes on the excess funds. In most circumstances, he also must pay a 10 percent penalty. Some states assess additional penalties.
The Internal Revenue Service allows limited exceptions when account-holders can withdraw funds from a 529 plan for non-educational expenses without paying the 10 percent penalty. However, the person who receives the money must still pay federal income taxes on the distribution. Exceptions include withdrawing the funds for the estate of the beneficiary if the beneficiary dies, or making the funds available to the beneficiary if he becomes disabled. The penalty also does not apply if the withdrawal is included in income because the beneficiary received a tax-free scholarship, veterans' educational assistance, employer-provided educational assistance, or any other tax-free payments for educational assistance.