Section 529 plans provide family members of college students (and the students themselves) a way to save money to pay for education-related expenses on a tax-advantaged basis. Contributions to a Section 529 plan are tax-deductible. Money in a Section 529 plan grows tax deferred, and any withdrawals from the plan to pay for qualified educational expenses are tax-free. However, not all education-related expenses are qualified for the purposes of tax-free withdrawals.
Qualified Educational Expenses
The Internal Revenue Service uses a broad definition of education-related expenses when processing Section 529 tax paperwork. Education-related expenses that qualify for tax-free withdrawals from Section 529 plans include college tuition, lab fees, books and supplies, the cost of a computer or laptop, and even the cost of room and board while attending college. However, since the primary purpose of the 529 plan is to assist the family in paying for college costs in the year the expense was incurred, the IRS does not recognize college loan repayment as a qualified educational expense.
Paying Off a Loan
To take a tax-free withdrawal from a 529 plan, you must either use the money directly to pay for a qualified higher educational expense (QHEE) or repay the loan in the year in which you took it out. Otherwise, you will not receive the tax break on the withdrawal, and you could be liable for an additional penalty of 10 percent of the 529 withdrawal attributable to the loan repayment.
Other Education Deductions
The interest on a qualified student loan is frequently deductible, even without using a Section 529 plan. Additionally, some college expenses are deductible as well. IRS rules allow you to deduct the cost of tuition, fees, books and supplies for professional accreditation, certification, continuing education and other programs, provided the instruction is for the purposes of furthering your current career, and provided that the educational program does not qualify you for a new line of work.
You or your dependent may be eligible for the American Opportunity Tax Credit. As of 2011, this credit is worth 100 percent of the first $2,000 of qualified educational expenses, plus 25 percent of the next $2,000 in qualified expenses, for a total of $2,500 per student per tax year. It is available for the first four years of a college education. Those pursuing a second bachelor's degree are not eligible. Additionally, there are income requirements for eligibility.