Today I’d like to talk about a somewhat complicated subject – 529 Savings Plans.
But before I get on with it, here’s the fine print. This is not legal, financial, or investing advice.. Please consult your financial advisor, tax attorney, CPA, or 529 plan administrator if you have questions related to your own plan.
Great, now that we got that out of the way, onto the heart of the matter.
A common misconception about 529 savings plans is that you’re restricted on how you can use all of the funds in your plan.
However, the balance in your 529 savings plan consists of two types of dollars. Your principal (or the total amount you’ve paid into the plan) and your earnings (the total gain you’ve accumulated above and beyond your contributions).
Because contributions into a 529 plan are made with after-tax dollars, you have the flexibility to withdraw up to the total amount you’ve contributed penalty-free and tax-free. You’ve already paid taxes on those dollars, and you’re legally entitled to use them however you see fit.
Your earnings – the amount your 529 savings balance has grown, above and beyond your total contributions – are subject to restrictions on how you can use them without incurring taxes or penalties. 529 plans are designed as a tax-favorable way to pre-pay education expenses. So plans restrict the use of funds to certain “qualified expenses” for education. However, these restrictions only apply to the use of your earnings, and not your principal.
Praxis tuition is not considered a “Qualified Education Expense”. So if you use any of the earnings portion of 529 plans to cover Praxis tuition, it may be subject to ordinary income taxes and a penalty.
If you use your 529 savings plan for a qualified education expense, there are no taxes or penalties. Your withdrawals will reduce your principal first. Once you withdraw the total amount you’ve contributed into the plan, any future withdrawals will be taken from the earnings.
If you use the earnings for non-qualified expenses, your withdrawals could be subject to federal income tax and withdrawal penalty. Additionally, each state has its own laws regarding 529 savings plans, and your withdrawals of earnings may also be subject to taxes or penalties at the state level.
For more reading on this, I recommend this article from Investopedia.