The Qualified State Tuition Plan, often referred to as the Sec 529 Plan, is a tax-beneficial incentive for parents, grandparents, and others to save money for an individual’s future college tuition and fees. There is no federal tax deduction for making contributions. But the tax benefit of these plans is that the earnings within the plan accumulate tax-deferred and then are tax-free when withdrawn if used for college tuition and related qualified expenses. Let’s take a simplified example.
Example: Jo’s parents establish a 529 plan when she is age 5, and contribute $10,000 to the plan. The $10,000 is invested in mutual funds that pay dividends of $400 per year. The tax on the dividends is deferred until the time when funds are withdrawn from the plan, and only payable if the distribution isn’t used for eligible education expenses. Let’s say that Jo enters college in 13 years and with the dividends earned over those years and an increase in the value of the original $10,000 to $15,000, the account is worth $20,200. Jo’s tuition and related expenses for her first semester is $25,000. The entire $20,200 is withdrawn to pay those expenses, so none of the dividends received and none of the $5,000 gain in the value of the account will be taxable. If Jo’s parents were in a 24% tax bracket, the tax savings by investing in the 529 plan compared to putting $10,000 in a regular brokerage account will be at least $1,530. The benefit would be compounded if more than $10,000 was contributed to the 529 plan.
Contributions - To maximize the tax benefits of a plan, it should be established for a child as soon after birth as possible when funds are available for contribution. For tax purposes, there is no limit on the amount that can be contributed, but contributions are considered gifts and each individual contributing to a plan would have to file a gift tax return if the gift exceeds the annual inflation-adjusted gift tax exclusion, which is $16,000 for 2022 (up from $15,000 for years 2018 through 2021).
A special gift provision permits a contributor to contribute up to 5 times the annual gift tax exclusion amount to a qualified tuition account in a single year and treat the contribution as having been made ratably over the five-year period beginning with the calendar year in which the contribution is made. Why would someone want to do this? Because by front-loading the contributions, they would accelerate the accumulation of earnings within the account. When making 5 years’ worth of 529 plan contributions in one year, a gift tax return is required in the year of contribution. If the contributor dies within the 5-year period, any amount contributed that is allocable to the years within the five-year period remaining after the year of the contributor’s death are includible in the contributor’s gross estate for estate tax purposes.
Although the income and gift tax laws don’t cap how much can be contributed to a qualified tuition plan, the 529 plans do limit the maximum amount that can be contributed per beneficiary based on the projected cost of a college education, and the maximum amount will vary between plans, though most have limits in excess of $200,000, with some topping $475,000. Generally, once an account reaches that level, additional contributions cannot be made, but that doesn’t prevent the account from continuing to grow.
Modifications – Since originating these plans, Congress has continued to modify the purpose of the plans by allowing plan funds to be used for more than just college tuition and fees. Over the years, they have allowed plan funds to be spent on additional expenses, including books, supplies, equipment, reasonable room and board, and computer technology.
More recently, the following qualified expenses were added:
- Elementary and Secondary School Tuition Expenses – The Tax Cuts and Jobs Act (2017) included a provision that treats withdrawals from 529 plans for elementary or secondary school (kindergarten through grade 12) tuition expenses as qualified expenses. However, the annual withdrawal for each beneficiary is limited to $10,000 (regardless of the number of 529 plans in the beneficiary’s name). This special $10,000 amount applies only for tuition (not books, supplies, room and board, etc.) paid to public, private or religious schools. Be Cautious – Since the greatest tax benefit and primary goal of these plans is accumulating tax-deferred investment income, which then can be withdrawn tax-free to pay qualified education expenses, using these funds too early will not achieve that desired goal. Thus, you should carefully consider whether to use the funds for elementary and secondary school education expenses or to wait and tap the account for post-secondary education, with the latter choice maximizing investment income.
- Apprenticeship Expenses – The category of qualified expenses was expanded by the Secure Act to include fees, books, supplies, and equipment required to participate in registered apprenticeship programs certified by the Secretary of Labor under Sec 1 of the National Apprenticeship Act, effective for distributions made in years after 2018.
- Repayment of Student Loans – Another Secure Act addition to 529 plan qualified expenses is effective for distributions after 2018 of up to $10,000–a lifetime limit–that may be used to pay the principal and interest on qualified higher education loans of the designated beneficiary or a sibling of the designated beneficiary. To prevent double-dipping, Sec 529 plan distributions used to pay interest on the education loan cannot be used for the above-the-line deduction allowed for student loan interest.
In addition to 529 plans Congress has also provided tax credits to help fund a child’s college education, though the rules for these credits aren’t entirely straight-forward. For example, one favorable twist of the tax code allows a grandparent (or others) to directly pay to the educational institution the child’s tuition without being subject to the gift limitations or reporting. On top of that, assuming the child is a dependent of their parent, the parent may qualify for a higher education credit even though the grandparent paid the tuition. The parent’s eligibility depends on their income, since the credits phase out once the adjusted gross income of the individual claiming the credit exceeds an amount based on filing status and the type of credit claimed.
If you need assistance with long-term education planning, give this office a call.