529 Plans (or Qualified Tuition Programs) are a unique option to help save and invest for qualifying education costs. For those in particular that anticipate they will be financing significant college expenses, 529 plans can become a key piece of a financial plan. While 529 plans are a powerful tool, it is important to understand the basic rules and tax considerations that make 529 plans a unique option. If those rules are not understood and navigated appropriately, the benefits of a 529 plan can be lost entirely or result in other unintended tax consequences. This article focuses on 529 college savings plans primarily, rather than 529 prepaid tuition plans, which in certain situations may also be an attractive opportunity to many.
529 Plan Basics
A 529 Plan allows an account owner to make contributions into an account for the benefit of designated beneficiary’s higher education costs.
A plan can name anyone as a beneficiary - even the account owners themselves in some plans. The beneficiary is usually someone with the intent to attend an institution of higher learning, though some K-12 programs may now qualify.
The contributions into the plan can be invested and grow over time before eventually being used to assist in funding the costs associated with higher education.
Qualifying education costs include, but are not limited to, tuition, books, room and board, and other fees.
529 plans are accessed via individual state plans. In most cases you do not need to live in the state to utilize it’s 529 plan, yet not all states offer the same quality of plan.
There are generally no contribution “limits” except what your specific state plan may limit you to, to ensure you are not potentially abusing any transfer tax rules (more on transfer tax below).
Plans can typically be “rolled over” from one state plan to another, so long as only a single rollover occurs every 12-month period.
There is no maximum age for contributions and no age at which funds in the plan must be distributed by.
529 plan assets may be considered assets of the parent, and not that of the child, for financial aid purposes - typically regardless of whether the plan is owned by the parent or child.
Starting in 2018, up to $10,000 per beneficiary, can be paid from a 529 plan in annual tuition at certain public, private or religious elementary or secondary schools.
The name 529 comes from the section within the Internal Revenue Code under which the rules that govern these unique savings vehicles are established.
Income Tax Considerations
A key reason many favor a 529 plan over investing through a traditional brokerage account when planning for college is the income tax benefits. Contributions into a 529 plan can grow federal (and usually state) income tax-free within the plan. Upon distribution out of the account to pay for qualifying education costs, the earnings that have accumulated also avoid federal (and typically state) income tax. This is different from traditional investing through a taxable account in which the account owner will pay tax each year for any earnings or gains created within the account. Many 529 owners may also be able to claim income tax deductions, credits or adjustments on their state income tax returns for contributions made to the state’s plan, though this benefit is state and plan specific and not available to all.
While the income tax benefits of 529s are evident, there are specific penalties or tax that can negate these benefits if funds are not used for qualifying costs. Namely, any distributions out of the 529 that does not go towards qualifying education costs will have the earnings component taxed as ordinary income. Further, this amount will also be subject to a 10% federal penalty. State taxes and penalties may also be applicable. At this point, the total tax and penalties imposed on improper use of 529 plan distributions may result in a higher loss of wealth than if the funds had been invested through a traditional taxable account the whole time.
Transfer Tax Considerations
Many individuals do not realize the US has a wealth transfer tax system governing gifts during life or bequests through an estate. While most taxpayers will never be exposed to paying transfer tax under the current regime (the exemption is currently in excess of $11 Million of gifts in life or at death, though this is always subject to change), there can still be an informational tax filing obligation that can cause 529 account owners headaches if they aren’t careful. Proper planning of contributions and beneficiary changes can help avoid the need to file gift tax returns.
A contribution to a 529 for the benefit of anyone other than yourself or your spouse is generally considered to be a gift. In 2019, a $15,000 contribution can be made to each beneficiary’s 529 plan without the need to file a gift tax return. Married couples can effectively double the gift-tax free transfer amount each year ($15,000 *2 = $30,000) there can become a gift tax return filing obligation (though no tax will be due). In fact, the IRS allows for a unique rule in which a lump sum of up to five years worth of tax-free gifts (5 * $15,000 = $75,000) can be made per beneficiary in a single year if made as a contribution to a 529 plan. This amount can again be doubled if a spouse elects this “super-funding” as well. This requires a special election, the filing of a gift tax return and no additional gifts to the beneficiary during the five-year span, without an additional filing and tax obligation. For those with means, it can be a great opportunity to get ahead on funding and planning for education costs if they anticipate those costs to be significant.
However, what if you’ve funded too much or your beneficiary decides not to pursue education? If the beneficiary is changed to someone else within the same family and same generation (i.e. sibling) or changed to someone within the same family and a generation older (i.e. parent) then typically gift tax is not an issue. Moving funds back down a generation can become an issue. Also, transferring funds from a child’s 529 to a grandchild’s 529 can result in gift tax obligations and other transfer tax concerns that are often best if avoided altogether.
Many may wish to consider how much is appropriate to fund an account with. While a 529 can offer great tax benefits, you rarely want to overfund a plan. Overfunding a 529 plan may result in the loss of liquidity and flexibility to finance other competing financial goals. This is where proper planning can make a noticeable difference.
Additionally, be sure to perform your research before selecting a state plan to invest with. The tax deduction or credit benefits of choosing one plan over another can be intriguing, but some state plans don’t offer as strong investment options as others. Different state plans many also have various restrictions on where funds can be spent (i.e school must be in state) so be sure to know the specific 529 plans rules before committing.
In the end, 529 Plans are no doubt a terrific way to save and invest in a tax-efficient manner for education expenses. However, there are many rules to consider in order to maintain the most flexibility and optimal outcome. It can be hard to know how much someone should save and invest for what may be an uncertain goal that is many years away. Taking appropriate steps ahead of time to plan and be thoughtful about when and how to fund college expenses can make a considerable impact on overall family wealth.
At Hudson Oak Wealth, we are happy to provide guidance on planning for education expenses and how to navigate the labyrinth of rules and decisions that confront those planning for these life events. Regardless, it is always advised that you seek the assistance of a qualified financial and tax professional before committing to a 529 plan or any other tax-favored investment program.
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