Use of 529 Plan Proceeds

Qualified tuition plans, also called 529 plans, allow you to save money in a tax-sheltered account, which means you won't pay taxes as it grows. Unlike Coverdell education savings accounts, 529 plans don't have an age limit, so you can use the money for educational expenses no matter what your age. However, if you don't use the proceeds for qualified expenses, you'll have to pay extra taxes and potentially penalties, too.

Qualified Expenses

Qualified expenses include tuition, fees and supplies incurred while attending an eligible educational institution, which includes colleges, trade schools and graduate schools. You can also count room and board if the student attends at least half-time. The half-time designation is based on the number of credit hours taken by the student and the number of credit hours deemed full-time by the school. Room and board costs equal the larger of the amount specified in the cost of attendance by the school or the actual cost, if the student lives on campus.

Qualified Expense Reductions

You must reduce your qualified expenses by tax-free aid, like scholarships and Pell grants, you use to fund your educational expenses. You also have to take out any costs used to claim a tax benefit for education, such as the American opportunity credit, lifetime learning credit or the tuition and fees deduction. For example, if the student has $30,000 in qualified expenses but has a $10,000 scholarship and uses $4,000 to claim the American opportunity credit, the student only has $16,000 left of qualified expenses.

Significance

Proceeds from 529 plans used for qualified educational expenses come out fully tax-free, including any earnings portion of the distribution. If you don't use the proceeds on qualified expenses, you'll still get the contributions portion of your withdrawal out tax-free, but the earnings will be taxed and, unless an exception applies, hit with an additional 10 percent tax penalty. For example, if you have a non-qualified distribution of $10,000 and $7,000 was contributions, you'll pay taxes on the $3,000 of earnings and, unless an exception applies, a $300 tax penalty.

Who Pays

If all or a portion of the earnings are taxable, the beneficiary taking the distribution from the 529 plan pays the taxes and penalties. For example, if you created a 529 plan for your son and he takes a non-qualified distribution, he has to include the income and penalties on his income taxes. However, if you're the beneficiary of the 529 plan and you take the non-qualified distributions, the extra income and penalties apply to your tax return.