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From, September 10, 2015

By Kate Stalter

There’s no question that 529 college savings plans have distinct advantages. In particular, they allow parents and grandparents to save for children’s college costs without paying any taxes on investment growth until the money is withdrawn.

To avoid penalties, the money must be used for qualified education expenses. At first blush, that may seem pretty straightforward. Typical college costs include tuition and other fees, as well as room and board.

But proper use of the funds accumulated in a 529 account requires some planning as well as knowledge of the rules. For example, while room and board is a qualified expense, there are some limits. To be covered with funds from a 529 account, room and board must conform to the school’s allowed amount, as outlined in federal loan documents, or must be the actual amount charged to a student living in on-campus housing.

“Students can’t take out tax-free distributions for lavish off-campus living,” says Jacob Gold, a Voya retirement coach in Scottsdale, Arizona. “Tax-free distributions for off-campus living must not exceed the cost of on-campus living.”

That’s just one area where a little knowledge can save a lot of grief, in addition to money. Here are some other ways people can make the most of their 529 accounts and avoid potential problems.

Have a plan for college funding. In many cases, the money in a 529 account won’t cover all expenses. Having a strategy in place before your child heads off to college will serve you better than trying to wing it, says Michael Fein, president of CIC Wealth in Owings Mills, Maryland.

According to the College Board, an association of colleges that administers standardized admissions tests and conducts research, the average cost of tuition and fees at a private college was $31,231 for the 2014-2015 school year. That’s a lot of money, but parents don’t have to fork it over all at once.

“The biggest planning mistake people make: The day their child turns 18 and gets accepted into college, they think they need to come up with $40,000 right there,” Fein says.

Instead, parents should plan cash flow as much as possible. Parents who have been paying for private high schools have a leg up, since they are already accustomed to hefty tuition payments, he says.

By paying for college out of pocket, to the extent possible, parents can allow their 529 accounts to continue growing, tax-deferred. Fein also points out that many colleges have payment plans, allowing parents or students to pay at regular intervals, interest-free, similar to how consumers pay other bills. That eliminates the need to make a big payment at the start of the semester.

“Do the best you can with cash flow, and if you have to take from the 529, then take it. Meanwhile, you’re paying zero interest. Conceptually, the money in your 529 should grow. It’s like a savings account. It’s there if you need it,” Fein says.

Peg Creonte, senior vice president of business development at Ascensus College Savings in Newton, Massachusetts, also says parents should hold off as long as possible when using funds from a 529 plan.

“Your account balance doesn’t need to cover everything. There is no rule saying you have to empty your account in the first year, and doing so might be shortsighted. Families may be better off using a portion of the account each year to help supplement overall costs,” she says.

Make sure your spending is qualified. While families are saving for college expenses, they typically give little thought to the exact ways in which their money will eventually be spent. However, before a son or daughter heads off to college, parents should ensure they are withdrawing money for the right purposes. A mistake could result in a penalty, on top of the taxation that already happens when account owners make withdrawals.

“People may not be aware of qualified higher education expenses, which are tuition, fees, books, supplies or any special type of equipment that a student may need,” says Tom Mingone, founder and managing partner of Capital Management Group in New York.

Expenses that don’t qualify include health insurance, even if a college requires it; club, sports and activity fees; computers, unless required; transportation to and from college; and repayment of student loans.

No double dipping. Students planning to take advantage of the American Opportunity Tax Credit as part of their higher education funding must be careful how they use tax credits in addition to money from a 529 plan.

Elizabeth DeBassio, senior financial advisor at Connecticut Wealth Management in Farmington, Connecticut, says families should think about the order in which they apply the various funding sources. The tax credits need to be used first, and then remaining expenses can be covered using the 529 account. Tax credits can be applied to costs covered out of pocket or with student loans.

“Say you have $40,000 of tuition expenses and you were using the American Opportunity Credit. Four thousand dollars of your qualified expenses would go towards the credit, and the remaining balance of $36,000 could be withdrawn from your 529 plan. If you took the whole $40,000, that would not be considered a qualified educational expense. You would have double dipped, because you used it once for the education credit and once for the 529 plan,” DeBassio says.

Similar restrictions exist with another program, the Lifetime Learning Credit, which offers a credit of up to $2,000 on the first $10,000 of eligible students’ qualified education expenses.

“If you’re using the Lifetime Learning Credit and your tuition is $20,000, then you only get full tax-free status on $10,000 that came out of the 529 because the other $10,000 [was] used for the Lifetime Learning Credit,” Mingone says. “So you can’t double dip, is the moral of the story.”

Mingone acknowledges that it can be complicated and suggests that students and their families get advice from a financial professional to sort out all the tax ramifications. “This is why we encourage people not to try this at home,” he says.