Editor’s note: This is part two of a three-part series about college 529 savings plans. Part one is When Choosing Funds for Your College 529 Plan, Don’t Make This Mistake, and part three is College 529 Savings Plans: How to Get the Most Out of Them.
When it comes to saving for college, the 529 plan remains extremely popular, with over $480 billion in assets as of 2021, according to Statista. In part one of this series, I reviewed how to maximize the growth in your 529. Many readers agreed with me that the age-based mutual fund options within 529 plans are often too conservative.
Still, many parents had additional questions about how 529s work. After all, the plans are complicated and have very specific rules and regulations. In this article, I will summarize answers to the most frequently asked questions on 529s.
Here's a selection of what you need to know about 529 plans:
What is a 529 plan? The name 529 comes from a section in the IRS tax code. Section 529 Qualified Tuition Programs are investment accounts administered by each state and intended to be used for qualified education expenses.
What are the tax benefits? Generally speaking, the earnings on 529 plan contributions can grow free from federal income tax, and withdrawals used to pay for qualified education expenses are free from federal income tax as well. Contributions are with after-tax money; however, most states offer a state income tax deduction for contributions, but this varies for each state.
Do I have to use my state's plan? No, you do not have to be a resident of that state to use another state's plan. However, there may tax advantages to using your own state. It's best to discuss with your accountant or financial adviser before opening an account.
What are “qualified” education expenses? Qualified education expenses include tuition, mandatory fees, textbooks, computers and software, supplies, required equipment and room and board if enrolled at least half-time. Room and board costs may not exceed certain amounts, either the actual invoiced cost of living on-campus or, if off-campus, the applicable rate determined by the qualified college or institution. Special needs services for a special needs beneficiary are also considered a qualified expense.
Does a 529 account have to be used for college? What about other schools, like a trade or vocation? 529 assets can be used at any eligible institution of higher learning. That includes four-year colleges, universities, qualifying two-year programs, trade schools and vocational schools. To qualify as an eligible institution, a school must be eligible to participate in student financial aid programs offered by the Department of Education.
Can 529 money be used for K-12 schools? A relatively new provision allows 529 account owners to withdraw up to $10,000 per year per student for private primary or secondary education. Unlike for college, this only applies to tuition, not to textbooks, computers or other fees or activities.
What if money is withdrawn for any other expense that isn't considered “qualified”? Any earnings on a non-qualified withdraw are subject to a 10% federal tax penalty. In addition, the earnings are subject to federal and, if applicable, state income taxes.
Are there any exceptions to the 10% penalty? What if my child receives a scholarship? Withdrawals following a beneficiary's death, disability or receipt of a scholarship (to the extent of the scholarship award) will not be subject to the 10% penalty. However, you will have to pay taxes on the earnings.
Who can open an account? Any individual who is of legal age to open an account and is a U.S. citizen or legal resident. In addition, U.S. trusts, corporations, partnerships and non-profit organizations may open an account.
Who is the owner? Typically, the parent is the owner. There can only be one owner, no joint ownership. However, there is an option for a successor owner if the account owner dies.
Who is the beneficiary? Usually the child, but it can be anyone — including yourself — and the beneficiary must be either a U.S. citizen or legal U.S. resident.
Who can contribute to the account? Any person or entity may make contributions to the account for the benefit of a beneficiary at any time.
What are the contribution limits? Contributions to 529 college savings plans are considered gifts for tax purposes. In 2021, gifts totaling up to $15,000 per individual qualify for the annual gift tax exclusion. This means if you and your spouse have three children you can gift $90,000 without gift-tax consequences, since each child can receive $15,000 in gifts from you and $15,000 in gifts from your spouse. Remember, this also includes non-529 gifts (such as gifts to a life insurance trust) so be sure to account for those.
Is there an overall limit to 529 plan accounts? Technically there are overall limits to 529 plan account balances. But limits can vary from state to state, generally from $235,000 to $529,000. Once the balance on a 529 plan reaches its limit, the plan will not accept new contributions. It's worth mentioning some plans will consider balances in other 529 plans for an overall aggregate limit. For instance, if the owner has more than one 529 for the same beneficiary, the plan may aggregate all the plan's balances to determine if the maximum limit has been reached.
What is the five-year election? You can “front-load” your gifts or contributions to a 529 plan and spread the gift over five years for gift tax purposes. For instance, if you contribute $80,000 in 2022, you can elect to use five years' worth of gifts in one year ($80,000 divided by the $16,000 annual exclusion). This is important for larger estates. Any 529 contribution over the annual exclusion amount is deducted from the lifetime gift exemption, which is currently $12.06 million per individual in 2022 (Source: SavingforCollege.com). Staying under the annual exclusion of $16,000 or using the five-year election will help preserve your lifetime gift exemption for other gifts.
What are the estate tax implications of a contribution to a 529 plan? Except in special circumstances, contributions to a 529 plan are not considered part of the estate of the contributor for estate tax calculation purposes.
Can you roll money from other accounts into a 529? Tax-free rollovers from one 529 into another 529 with the same beneficiary are permissible once every 12 months.
Can you roll UGMA or UTMA assets into a 529? Yes, transfers from a UTMA/UGMA are permissible, but restrictions apply. To transfer UTMA/UGMA accounts to a 529 plan, you may be required to sell the UGMA/UTMA assets first. Generally speaking, UTMA/UGMA accounts do not allow for changing the beneficiary, and as such this restriction will carry over to UTMA/UGMA assets transferred to a 529. It's best to consult with a financial or tax adviser before transferring UTMA/UGMA assets to a 529.
Can you change the beneficiary? A 529 account owner may change the beneficiary at any time. However, the new beneficiary must be a member of the family of the previous beneficiary to avoid being considered a withdrawal. If the account owner changes the beneficiary to a new beneficiary who is more than one generation younger than the previous beneficiary, the generation-skipping transfer tax may be triggered. For example, a parent changing the beneficiary from their child to their grandchild is considered a generation-skipping transfer.
Can you change the investments in a 529 account? Currently, the IRS allows an account owner to change the mutual fund or funds only twice a year. There are currently no “aggregation rules” with respect to investment changes, so the investment change limit of two per year is per account. For example, if an owner and beneficiary have other 529 accounts, each account will have their own two-change-per-year limit.
What is the treatment of 529s for financial aid? 529 assets may affect a beneficiary's ability to qualify for federal need-based financial aid. A 529 is an asset of the student's if the student is considered an independent student for tax purposes or an asset of the parent if the if the student is a dependent student. A student is considered independent if, among other criteria, he or she is at least 24 years of age, or is married, or a graduate or professional student. Generally, if a student is considered “dependent” and the 529 is a parent's asset, the more favorable the treatment for financial aid. A 529 should not affect the eligibility for a merit-based scholarship.
As you can see, a 529 education savings plan has many rules. But if one follows the rules, the 529 is an unapparelled place to save for college and private school. There are several advantages, including the ability to defer taxes on earnings, withdraw earnings tax-free for qualified education expenses, plus the ability in some states to deduct — within limits — the contribution from state income taxes. Most accounts have several investment choices as well, from auto-pilot programs, such as age-based options, to the ability to pick individual funds, all of which could help contributions grow and keep pace with future college costs.
The 529 plan is very flexible too, with the ability to change beneficiaries without incurring a penalty (assuming to another qualified beneficiary). For new parents, the low minimum contributions and the ability to invest automatically are attractive features. In addition, there are advantages for high-income earners, such as no income limitations to set up an account, very high contribution rates, and a contribution is a completed gift for estate tax purposes if estate tax planning is important.
Higher education is a way to a better life for many people, and the 529 plan remains an excellent way to help get you there.
The views and opinions expressed in this article are solely those of the author and should not be attributed to Summit Financial LLC. Investment advisory and financial planning services are offered through Summit Financial, LLC, an SEC Registered Investment Adviser, 4 Campus Drive, Parsippany, NJ 07054. Tel. 973-285-3600 Fax. 973-285-3666.
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Investment advisory and financial planning services are offered through Summit Financial LLC, an SEC Registered Investment Adviser, 4 Campus Drive, Parsippany, NJ 07054. Tel. 973-285-3600 Fax. 973-285-3666. This material is for your information and guidance and is not intended as legal or tax advice. Clients should make all decisions regarding the tax and legal implications of their investments and plans after consulting with their independent tax or legal advisers. Individual investor portfolios must be constructed based on the individual’s financial resources, investment goals, risk tolerance, investment time horizon, tax situation and other relevant factors. Past performance is not a guarantee of future results. The views and opinions expressed in this article are solely those of the author and should not be attributed to Summit Financial LLC. Links to third-party websites are provided for your convenience and informational purposes only. Summit is not responsible for the information contained on third-party websites. The Summit financial planning design team admitted attorneys and/or CPAs, who act exclusively in a non-representative capacity with respect to Summit’s clients. Neither they nor Summit provide tax or legal advice to clients. Any tax statements contained herein were not intended or written to be used, and cannot be used, for the purpose of avoiding U.S. federal, state or local taxes.
Michael Aloi is a CERTIFIED FINANCIAL PLANNER™ Practitioner and Accredited Wealth Management Advisor℠ with Summit Financial, LLC. With 21 years of experience, Michael specializes in working with executives, professionals and retirees. Since he joined Summit Financial, LLC, Michael has built a process that emphasizes the integration of various facets of financial planning. Supported by a team of in-house estate and income tax specialists, Michael offers his clients coordinated solutions to scattered problems.
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