What it means
Many countries encourage families to save for education through special accounts that grow with tax advantages. In the United States, the best-known examples are 529 plans and Coverdell education savings accounts.
The tax benefit usually depends on the money being used for qualified expenses. If withdrawals match qualified higher education expenses, the investment growth is normally free of income tax.
If the withdrawals exceed those expenses, the extra growth portion is generally taxable and may be subject to an additional penalty. Anyone using these accounts therefore needs to know exactly what counts.
Qualified expenses generally include tuition and mandatory fees, books, supplies and equipment required for courses. Room and board may count if the student is enrolled at least half-time, up to limits set by the school or tax rules.
Computers and internet access may also count when used mainly by the student. Expenses that do not qualify include things like travel to the campus, health insurance and student loan repayments, though specific rules vary and have changed over time.
The tax authority publishes the current list, and details can differ by account type. Families should check the latest guidance before taking a withdrawal.
The money used for expenses cannot be counted twice. If a student receives a tax credit for tuition paid, or tax-free scholarships, the same expenses cannot also be used to justify a tax-free withdrawal.
Records such as receipts and statements should be kept to show how the money was spent. A nuance for those who plan ahead is that the amount of qualified expense must be matched to the year of the withdrawal.
Taking the money out in one year and paying the bill in another can create a mismatch. Planners therefore time the withdrawals to match the dates the school bills are paid.
In practice
Real-world examples.
Example
A student pays $9,000 of tuition and $600 for required books. The parents withdraw $9,600 from a 529 plan to pay these costs. The whole withdrawal matches qualified expenses, so the investment growth is tax-free.
Example
A family takes $12,000 out of a savings account but the student's qualified costs are only $8,000 after a scholarship. The extra $4,000 is not covered by qualified expenses. Part of the growth in the withdrawal becomes taxable, and an additional penalty may apply.
Example
A college student living off campus keeps a spreadsheet of tuition, fees, books and a documented housing cost within the school's published allowance. At the year end, the family uses it to show that its withdrawals matched qualified expenses.
Formula
Calculation
Tax-free earnings = earnings portion of the withdrawal x (qualified expenses / total withdrawal), limited to 100%
Taxable earnings = earnings portion of the withdrawal - tax-free earnings
Suppose a family withdraws $10,000 from an education savings account, of which $2,000 is investment growth and $8,000 is original contributions. Qualified higher education expenses for the year are $8,000. Tax-free earnings = 2,000 x (8,000 / 10,000) = $1,600, so the taxable earnings are 2,000 - 1,600 = $400. If the expenses had been $10,000 or more, the whole $2,000 of growth would have been tax-free.Case study
Seen in the real world.
Hartwell Family is an illustrative, fictional household that saved $60,000 in a college savings account for their daughter, with $15,000 of it being investment growth. In her first year, the college billed tuition and fees of $14,000, and the family also spent $1,500 on required books and supplies.
The parents withdrew $15,500 to cover all of it. Because qualified expenses of $15,500 matched the withdrawal, the whole amount was free of income tax. They kept receipts, the billing statement and the account statement together for the tax return.
In the second year, the daughter won a scholarship covering $5,000 of tuition, which reduced her qualified expenses. The parents adjusted the withdrawal downwards. The illustrative lesson was that the scholarship, the withdrawal and the tax credit must all be coordinated, so that no expense is counted twice.
Watch out
Common mistakes.
- Withdrawing more than the year's qualified expenses, which makes part of the investment growth taxable and potentially subject to a penalty.
- Counting the same expense twice, once for a tax credit and again to justify a tax-free withdrawal.
- Assuming every education-related cost qualifies, when items such as travel and student loan repayments often have separate rules.
Questions
People also ask.
What counts as a qualified higher education expense?
Typically tuition, mandatory fees, books, required supplies and equipment, and in some cases room and board, although the rules should be confirmed with the tax authority.
Do scholarships reduce qualified expenses?
Yes, tax-free scholarships generally reduce the amount of expenses that can be treated as qualified for a tax-free withdrawal.
Is QHEE a US-only term?
The abbreviation is used mainly in the United States, though other countries have similar rules for education savings.
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