Opening Up the 529 Mailbag

We've recently been getting lots of interesting reader questions related to 529-college-savings plans. So let's dive right in.

Question: Can I pay off my college loans with leftover 529 funds?

Answer: With so many recent (and not-so-recent) college grads grappling with college debt, it's no wonder this question comes up. But the fact is that 529 funds cannot be used to pay off college loans. 

The Internal Revenue Service requires that 529 assets be used only for qualified expenses, which include tuition, fees, books, supplies, room and board (if the student is carrying at least half of a full course load as defined by the school), and services required for enrollment by special-needs students. Even if you took out loans to pay for these things, the IRS also requires that 529 funds be withdrawn the same year the expenses were incurred. Withdrawals for unqualified expenses mean paying taxes on earnings plus a 10% penalty, so if you think you may need to take out loans at some point you're best off trying to use up 529 funds first. That way, you avoid paying taxes and the penalty, and also avoid having to take out a bigger loan.

If you do end up with unused 529 assets, one thing you can do to avoid paying taxes and a penalty is to roll them into a family member's 529 account. (You can read more about which family members are eligible here.) You might even see if there's a way for that family member to pay you back, which would provide you with cash to pay off your loan.

Question: What happens if I save money in a 529 and then my child attends college abroad? Do I forfeit the money?

Answer: Not necessarily. Assets in 529 plans may be used to pay for qualified expenses at more than 400 colleges outside the United States that have federal school codes. To see whether a specific school meets eligibility requirements, go to the U.S. Department of Education's Federal Student Aid website, select "Foreign Country" in the State drop-down menu, and type in the name of the school. Or to see a list of eligible schools, leave the "School Name" field blank. Foreign colleges that have federal school codes not only are eligible for students to use 529 funds but also allow federal financial aid. For study-abroad programs, 529 eligibility depends on the eligibility of the school to which tuition is paid during the program.

Once you've identified a foreign school and found its federal school code, it's a good idea to contact the school directly to confirm that you may use 529 funds to cover eligible expenses. And remember that 529 funds generally don't cover transportation costs, meaning you may end up paying out-of-pocket for airfare to and from the school.

Question: I plan to open a 529 plan to help with my grandchildren's college costs. Should I open it in the state where they live?

Answer: There's no good reason to choose a 529 plan based on where the beneficiary lives. That's because 529 plans can be used to help pay for schooling in any state. Even if you and your grandchildren live in different states, you could open a 529 account in a third state, your grandkids could attend college in a fourth state, and all would be well.

However, before opening a 529, you should consider a few important factors. The first is whether you are eligible for a state income tax break for contributing to your own state's 529 plan (more than 30 states offer this perk). Second is the quality of your in-state plan, which you can research using Morningstar's 529 Plan Center. If your state offers a tax break but its plan is only so-so, it may still be worth your while to use it in order to qualify for the tax break. But if you live in a state that does not offer a tax break or that has no state income tax, you ought to take a look at one of the plans that Morningstar analysts rate highly, such as the Gold-rated plans offered by Alaska, Maryland, Nevada, and Utah.

One last thing to remember: If you think your grandchildren may qualify for need-based financial aid, keep in mind that the amount of their awards could be affected by any 529 funds they use that are under your control. That's because when a student uses 529 funds that come from an account owned by someone other than the student and/or his or her parents, it is considered student income in the following year's financial aid calculations. One way around this is for the beneficiary to wait to use grandparent-owned 529 funds until his final year in school, after which he will not be applying for financial aid anymore. For more strategies regarding how grandparents can help with college costs, see this Short Answer article. 

Questions: What happens to the money in my 529 account if I declare bankruptcy? Can my creditors get at it?

Answer: The rules regarding bankruptcy and 529 accounts are rather complex. Generally, a beneficiary who declares bankruptcy is protected from having his account subjected to the bankruptcy because technically he doesn't own the money. However, the rules are different if the account owner declares bankruptcy. In that case, federal law says contributions made to the account at least two years prior to the bankruptcy are protected as long as the beneficiary is the account owner's child, stepchild, grandchild, or stepgrandchild. For contributions made between one and two years before the bankruptcy only $5,850 is protected for each beneficiary. Anything added within one year of the bankruptcy may be subject to it.

However, states may add their own rules regarding 529 assets and bankruptcies. Many states protect 529 assets from bankruptcy proceedings regardless of whether they involve the beneficiary, the account owner, or a third-party donor. But these protections are typically restricted to assets held in in-state 529 plans. If you have a 529 account and are in bankruptcy or are worried you may soon be, talk to your attorney about your state's rules regarding 529-asset treatment.

Have a personal finance question you'd like answered? Send it to TheShortAnswer@morningstar.com.