Many parents are looking for ways to save for their child’s education and a 529 Plan is an excellent way to do so. Even better, is that they are now available to parents wishing to save for their child’s K-12 education as well as college.
Every state has a program allowing persons to prepay for future higher education, tax-free, and you may open a Section 529 plan in any state. Contributions must be in cash, and they must not total more than reasonably needed for higher education (as determined initially by the state). Neither account owner or beneficiary may direct investments, but the state may allow the owner to select a type of investment fund (e.g., fixed income securities), and to change the investment annually, and when the beneficiary is changed. The account owner decides who gets the funds (can pick and change the beneficiary) and is legally allowed to withdraw funds at any time, subject to tax and penalties (discussed later).
Unlike some of the other tax-favored higher education programs such as the American Opportunity and Lifetime Learning Tax Credits, federal tax law doesn’t limit the benefit only to tuition. Room, board, lab fees, books, and supplies can be purchased with funds from your 529 Savings Account. Individual state programs could have a more narrow definition, however, so check with your particular state.
Each 529 Plan has a Designated Beneficiary (the future student) and the Account Owner. The account owner may be a parent or another person and is typically the principal contributor to the program. He or she is also entitled to choose—as well as change—the beneficiary
The account owner is not subject to income limitations; however, contributions can not exceed the amount necessary to provide for the qualified education expenses of the beneficiary. There is no income limit as to who may be an account owner. There’s only one designated beneficiary per account. Thus, a parent with three college-bound children might set up three accounts.
529 plan distributions are tax-free as long as they are used to pay qualified higher education expenses for a designated beneficiary. Qualified expenses include tuition, required fees, books, supplies, equipment, and special needs services. For someone who is at least a half-time student, room and board also qualify.
Section 529 distributions can be tax-free even though the student is claiming the American Opportunity Credit, Lifetime Learning Credit, or tax-free treatment for a Section 530 Coverdell distribution–provided the programs aren’t covering the same specific expenses. Qualified expenses include computers and related equipment used by a student while enrolled at an eligible educational institution; however, software designed for sports, games, or hobbies does not qualify unless it is predominantly educational in nature
Furthermore, starting in 2018, “qualified higher education expense” also includes up to $10,000 in annual expenses for tuition in connection with enrollment or attendance at an elementary or secondary public, private, or religious school.
Federal Tax Rules
Income Tax. Contributions made by the account owner or other contributor are not deductible for federal income tax purposes. Earnings on contributions grow tax-free while in the program. Distribution for a purpose other than qualified education is taxed to the one receiving the distribution. In addition, a 10 percent penalty must be imposed on the taxable portion of the distribution, comparable to the 10 percent penalty in Section 530 Coverdell plans. Also, the account owner may change the beneficiary designation from one to another in the same family. Funds in the account roll over tax-free for the benefit of the new beneficiary.
Gift Tax. For gift tax purposes, contributions are treated as completed gifts even though the account owner has the right to withdraw them – thus they qualify for the up-to-$15,000 annual gift tax exclusion. One contributing more than $15,000 may elect to treat the gift as made in equal installments over that year and the following four years, so that up to $75,000 can be given tax-free in the first year.
Estate Tax. Funds in the account at the designated beneficiary’s death are included in the beneficiary’s estate – another odd result, since those funds may not be available to pay the tax. Funds in the account at the account owner’s death are not included in the owner’s estate, except for a portion thereof where the gift tax exclusion installment election is made for gifts over $15,000. For example, if the account owner made the election for a gift of $75,000 in 2018, a part of that gift is included in the estate if he or she dies within five years.
Tip: A Section 529 program can be an especially attractive estate-planning move for grandparents. There are no income limits, and the account owner giving up to $75,000 avoids gift tax and estate tax by living five years after the gift, yet has the power to change the beneficiary.
State Tax. State tax rules are all over the map. Some reflect the federal rules, some quite different rules. For specifics of each state’s program, see http://www.collegesavings.org.
Considering the wide differences among state plans, federal and state tax issues, and the dollar amounts at stake, please call before getting started with a 529 plan.