Saving for your loved one’s education can be a daunting task, but with options such as a 529 Plan, saving for the future can be effortless. 529 Plans, legally referred to as “qualified tuition programs,” are state-sponsored college savings plans that offer numerous tax and financial benefits. This article will discuss some of those benefits and will help shed light on some common misconceptions surrounding 529 Plans.
Unfortunately, contributions to a 529 Plan are not tax deductible at the federal level, but may be deductible at the state level. However, earnings grow tax-free and distributions are generally non-taxable when used for qualified higher education expenses, and elementary and secondary school tuition within defined limits.
Qualified higher education expenses generally include tuition, fees, books, equipment, and supplies required for attendance at an eligible education institution. Prior to the Tax Cuts and Jobs Act (TCJA), elementary or secondary school tuition was not considered a qualified higher education expense. However, with the implementation of the TCJA in 2018, the definition of qualified higher education expenses was expanded to include expenses for elementary and secondary (K-12) tuition at public, private, or religious schools. For tax years beginning after 2017, 529 Plan beneficiaries can receive tax-free distributions to pay for these expenses, up to $10,000 per beneficiary. The application of the K-12 rules for 529 Plans vary by state, so it is important to check your state's rules for its implementation of 529 Plans for K-12 educational expenses. Finally, if the beneficiary receives any educational assistance and/or tax-free scholarships, 529 Plan qualified expenses must be reduced by such amounts.
There are no income or age restrictions for contributors or beneficiaries of 529 Plans. Thus, any person can fund a 529 Plan and name anyone as the beneficiary—a child, a grandchild, a relative, a friend, or even himself. Each plan can have only one designated beneficiary, but there is no limit to the number of plans each contributor can create. If you change the designated beneficiary to another person, there are no tax consequences. In addition, there are no penalties if you roll one 529 Plan over to another for the same beneficiary.
Many individuals fear that if their loved one does not use the 529 Plan savings (for example, they decide not to go to college or receive a fully paid scholarship) that the contributions and earnings are “lost money,” but this is not true. If the intended beneficiary does not take advantage of the education savings accumulated in the 529 Plan, there are a variety of options for utilizing the money. One option is to change the beneficiary of the plan to another qualified individual and use the funds for their qualified education expenses. Another option is to keep the funds as an emergency account. In this circumstance, earnings will continue to grow tax-free and distributions will only be taxed and penalized upon their withdrawal if used for non-qualified expenses. While this option does not avoid taxation and penalties, it can help spread them out over time and alleviate tax burdens associated with a lump sum withdrawal.
Direct rollovers from 529 Plans into an individual retirement account (IRA) are not permitted by the Internal Revenue Code; however, there are ways of “moving” the 529 Plan assets into an IRA. Individuals may take a nonqualified distribution from a 529 Plan savings account and then invest the cash into an IRA, though there are tax consequences to such action. The earnings portion of the nonqualified distribution will be taxed as ordinary income and the entire distribution will be subject to a 10% penalty. While this option is certainly not the most tax advantageous, it is an available option should you decide the 529 Plan savings could be better utilized in an IRA.
While setting up a 529 Plan account is simple and straightforward since most applications only require basic personal information for the account owner and beneficiary, the process of selecting a 529 Plan that fits your needs may take more time. Contributors have the option to choose between an in-state or out-of-state plan. Many states offer state tax deductions for in-state plans, while out-of-state plans may have lower fees or better investment options. Fortunately, distributions from one state’s plan can be used to pay for qualified expenses at eligible institutions in another state.
Do you have questions regarding 529 Plans and how to best utilize them? Contact a P&N tax advisor to discuss the options available to meet your needs.
Nikki McDonald contributed to this article.