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The Basics Q&A: Saving for College

Q: I just opened a 529 college savings account for my daughter. How can I use it?

A: Assets in a 529 college savings plan have to be spent on "higher education" in order to come out of the account tax-free. Besides tuition and fees—the biggest educational bills you'll probably face—other eligible expenses include such things as room, board, books, expenses for the purchase of computer or peripheral equipment, computer software, or Internet access and related services, and required supplies, as defined by the Internal Revenue Code.

Here's an example of where you might run into problems if you try to test the limits of what "higher education" means: Using 529 funds to pay for a music degree at an accredited institution for your daughter would be fine. But if you use them to pay for private piano lessons, you'll be penalized – which basically means that you'll have to pay income tax on the earnings portion of the money you withdrew, as well as a 10% additional federal tax. You will never pay additional federal tax on the principal portion of your withdrawal, regardless of what it is used for.

 

Answered by:

MLWM_the-basics-q-and-a-saving-for-college-richard-polimeni

Richard J. Polimeni, director, Education Savings Programs, Bank of America Merrill Lynch

The rules are fairly flexible when it comes to how many students can benefit from your 529 account. Suppose you set aside $200,000 in an account for your daughter and you spend only half of the money. You could transfer the rest to an account for your son or even a niece or nephew. If there's still something left over, it can stay in the account indefinitely—and be ready, decades later, to help pay the cost of a grandchild's education. Or it could even be used to fund your own or your spouse's continuing education.

If you want to set aside money for lessons or other educational activities that a 529 doesn't cover, you could start a trust or a custodial account under the Uniform Gifts/Transfer to Minors Act. There are potential drawbacks to that strategy: these gifts can't be taken back and don't allow you to transfer assets between beneficiaries. What's more, once the child you designate as beneficiary reaches a certain age—which varies by state—he or she will be free to spend the money for purposes other than education. If that's a concern, you may decide you're better off using a typical savings account to earmark money for educational goals that a 529 doesn't cover. Your financial advisor can help you figure out what makes the most sense for your family.

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We'll answer frequently asked questions here.

3 Questions to Ask Your Advisor

  1. Given my circumstances, what are the most advantageous ways for me to consider saving for a child's education?
  2. Can the way I choose to save for college have an impact on my estate plan?   
  3. With so many different 529 plans available, how can I decide which one is best suited to my family's needs?

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