*This article has been updated to reflect the Tax Cuts and Jobs Act of 2017 revisions to 529 plans.
A 529 plan is a savings plan operated by states, or eligible educational institutions, to help people save for college, and with the recent signing of the Tax Cuts and Jobs Act, can now be used for private K-12 school. 529 plans offer tax advantages to incentivize saving for qualified education costs. These costs are most commonly thought of as required expenses for traditional colleges but are more broadly defined to include costs associated with any eligible post-secondary educational institution, such as a vocational school, or the tuition cost of a private K-12 school. The advantages of various plans vary depending on the state or institution operating the plan, and the 529-plan owner’s residency. The most common incentive is a potential state income tax deduction for contributions to the 529 plan. The most significant advantage of a 529 plan is the earnings are not subject to federal income taxes and also generally not subject to state income taxes, as long as the distributions are qualified.
In most situations, a 529 plan account is owned by a parent or grandparent, and the beneficiary is the student that will use the money for school; however, anyone can own an account, and list anyone as the beneficiary. The owner is permitted to change the beneficiary of the 529 plan to a qualified family member.
There are some limitations to contributions to 529 plans. Contributions are treated as a gift, and as such, are subject to the annual gift tax regulations. You may contribute up to $14,000 ($28,000, if married) to a 529 plan for a beneficiary without filing a gift tax return each year. There is a special rule that allows for the $14,000 limit to expand to $70,000 ($140,000, if married). The provision allows for a lump-sum contribution of up to five years of annual gift exclusion, provided no other gifts are made to the beneficiary. Additionally, there is a limit to the total amount of money allowed in a 529 plan. The limits vary per plan but are generally in the $250,000 to $300,000 range.
If a distribution from the 529 plan does not meet the qualified status, the earnings will be subject to income taxation, and the IRS will assess a 10% penalty tax on the distribution. The IRS defines a qualified distribution as a withdrawal to cover expenses required by the post-secondary educational institution for enrollment, such as tuition, fees, books and room and board. For room and board to qualify, the beneficiary must be enrolled at least part-time. Unless a computer is a requirement for enrollment by the post-secondary educational institution, a distribution to purchase a laptop is not a qualified expense. Also, transportation costs to and from college are not considered qualified expenses, and as such, are not permitted without penalty. Specific to the private K-12 school, only tuition expenses are considered a qualified distribution, and the maximum qualified distribution is capped at $10,000 per the calendar year.
A question that clients frequently ask regards distributions covering room and board for beneficiaries that do not live in housing provided by the educational institutions. As long as the beneficiary is at least a part-time student, off-campus room and board expenses are deemed qualified as long as the costs do not exceed the institution’s room and board expenses.
Another question that comes up frequently is, “How does the 529 plan impact potential financial aid?” Actually, 529 plans are quite advantageous in that they really do not impact the financial aid calculation much if the account owner is a parent. If a parent is the owner of the 529 plan, then up to 5.64% of the value of the account is included in determining the Expected Family Contribution (EFC); however, if the account is owned by a non-parent, typically a grandparent, then account distributions are counted as student income and will be assessed at 50%.
A third question that comes up frequently is, “What happens to the account if the beneficiary receives an academic or athletic scholarship?” You do not have to do anything with the plan, and can choose to instead keep the account for future expenses, such as graduate school. Conversely, you could change the account beneficiary to another qualified family member, such a younger sibling who is preparing for college. A third option is to distribute the funds. Although any gain on the investment would be taxable, you would not be subject to the 10% penalty tax.
Although there are some minor drawbacks associated with utilizing a 529 plan as a tool for saving for education, the benefits far outweigh the disadvantages. To learn more about 529 plans, or if you would like to assess whether one might be beneficial for you, please contact us.
*Want to know more about 529 Plans? Read our article on how to contribute a gift to a 529 plan.