What is a Qualified Expense?
Qualified expenses are expenses that are eligible for tax- and penalty-free distributions from your 529. A subset of qualified expenses is also eligible for the American Opportunity Tax Credit, but only if you don't use your 529 to pay them.
529s can be used for most college expenses:
Tuition and fees
Room and board, whether on-campus or off
Books
Required supplies including a computer and internet access
Of course, that's far from all the college expenses. Some that are NOT qualified include:
Travel between home and college
Health insurance-- even if it's required
A car
Personal expenses
Extracurriculars
New student orientation
Dorm decor
Nonqualified expenses are subject to tax and a 10% penalty on the earnings portion of the distribution from the 529. What does that mean? Your 1099-Q will show how much of your distribution was contributions (money you put into the account) and how much was earnings (growth in the value of the account). The earnings portion is the only portion subject to tax and penalty, although contributions that are used for nonqualified expenses may be subject to clawback of state tax benefits.
Some qualified expenses are a little confusing. Take off-campus room and board. Your off-campus living expenses are only qualified up to the dollar amount set by your college. That means that if your college says off-campus room and board cost $13,000 annually and your annual apartment rent is $12,000, only $1,000 of meal costs are qualified. In some cases, colleges break down the off-campus allowance between room and board and yours may or may not line up with theirs.
One frequent question I get is, "Do I need to keep all my student's grocery receipts for my taxes?" Unfortunately the answer is technically yes. You don't need to submit them with your taxes, but in the event of an audit you would be required to show proof of the expense. How do you minimize an audit? By making sure the distributions from the 529 go to your student or their college, rather than to you, so that the SSN on the 1099-Q from the 529 matches the SSN on the 1098-T from the college.
What if you have extra 529 money that you want to use for non-qualified expenses? If your student has a scholarship, you may be able to access those dollars tax- and penalty-free. You do not pay the 10% penalty on nonqualified withdrawals if the excess withdrawal is due to a scholarship. Simply said, that means that if your student has a $10,000 annual scholarship, you could withdraw $10,000 each year from their 529 and only pay taxes on the earnings, not the 10% penalty. If you have the distribution go to the student, the first $1,350 is tax-free and the next $1,350 is taxed at the student's rate-- which is likely to be zero. Even if the distribution were subject to the 10% penalty, in some cases it still makes sense to use 529 money for these expenses if there is excess in the 529.
The American Opportunity Tax Credit has a more limited set of qualified expenses: only tuition, fees, books and required supplies are eligible for the AOTC, and you cannot use a qualified distribution from your 529 for an expense for which you claim the AOTC. As above, you can use your 529 and then report the AOTC-eligible portion of the distribution as a nonqualified distribution if you have excess 529 funds and are eligible for the AOTC.
