Do's, Don'ts for Using College Savings Withdrawals

One of the biggest benefits to 529 college savings plans is that they grow tax-deferred and withdrawals are exempt from federal income tax.

But there's a catch: In order to avoid taxes and penalties, the money needs to be used for what are known as qualified higher education expenses at an eligible institution.

"It's actually a two-pronged test: what type of expense, and what type of school," says Chris Stack, attorney and managing consultant for the website

Account holders who take money out of a 529 plan and do not use it for a qualified education expense face a 10 percent penalty on the earnings on top of the ordinary income tax they'd pay on earnings.

Here are some do 's and don'ts to avoid getting penalized on 529 plan withdrawals.

[Learn five steps for using funds from a 529 plan.]

Do know what expenses are considered qualified: "A good checklist for students and families to remember is their 529 expenses can include tuition, room, board, books and supplies," says Jodi Okun, president and founder of College Financial Aid Advisors in California. Computers, Internet access and software -- excluding games -- are now qualified expenses as well.

Off-campus rent and grocery bills also qualify, but should not exceed the allowance for room and board included in the school's federal financial aid calculations, says Keith Bernhardt, vice president of retirement and college products at Fidelity Investments, which manages 529 plans in four states.

"So if little Johnny wants to stay in the penthouse in the high-rise off campus, and the rent is really high, the full rent probably wouldn't be covered by what's considered a qualified expense," Bernhardt says.

[Know the 10 questions college financial aid advisers wish parents would ask.]

Don't use a 529 withdrawal for travel expenses: Airline tickets to and from school, as well as other transportation expenses, may be the biggest expense for some families that doesn't qualify, Stack says.

"People may mistakenly think because it's an expense necessary for the student to attend school that it qualifies, but it in fact doesn't," Stack says.

Apartment furnishings and entertainment costs are also not typically considered qualified, Bernhardt says.

Do check to see if your institution is on the list of eligible institutions: "Most people are unaware of the thousands of institutions, and different types of institutions, that do qualify for 529 tax-free withdrawals: everything from traditional colleges and universities, to scuba diving and culinary institutes," Stack says.

There are also about 400 international institutions that qualify. Families can check a list kept by the Department of Education.

Don't forget about student status: Keep in mind that the student needs to be enrolled at least half time to be eligible for room and board 529 tax benefits, Stack says.

Do consider who will receive disbursements: There are three ways to withdraw from a 529 account: a direct distribution to the account owner, a distribution to the beneficiary or a distribution to the school. From a tax-reporting perspective, having the money sent directly to the school may be the cleanest.

"The simplest way," Okun says, is to "contact the company that is holding the 529 and have them write a check to the college."

However, that doesn't work for all expenses, especially if the student is living off campus. Bernhardt says that "checks are not necessarily the preferred way schools want to get paid nowadays."

Many schools prefer to use a debit system, he says, asking for a bank account and routing number to process tuition payments on certain dates. Account holders or beneficiaries who go this route can take money from a 529 in anticipation of the withdrawal. Or, those who have the funds can also pay the school and other expenses first, and then pay themselves back.

"They simply need to have record that the payment was made," Bernhardt says.

Do match up expenses and withdrawals in the same period: Account holders who reimburse themselves need to do so within the same tax year, Stack says.

[Check out these tax time tips for college savers.]

It's important to keep good records in case the IRS asks questions, Bernhardt says.

Don't "double dip" on tax benefits: There are some valuable education tax credits that college students can take advantage of -- such as the American Opportunity Tax Credit and the Lifetime Learning Credit -- but account holders can't double up tax benefits for the same college expenses.

Bernhardt suggests subtracting the tax credits from your college expenses first, then using 529 funds to pay for the rest.

Do know the rules for scholarships: If a student gets a scholarship, the tax code waives the 10 percent penalty on a 529 withdrawal of the amount equal to the scholarship. Families will still need to pay taxes on the earnings that grew in the tax-deferred 529 account.

"Because it's just on the earnings component, the tax consequence is not as adverse as many believe," Stack says.

Trying to save for college? Get tips and more in the U.S. News College Savings 101 center.

More From US News & World Report