529 Plan Rules

529 Plan Rules

Posted On March 11, 2020 By Scott Stratton, CFP(R), CFA In College Savings /  

College is often a parent’s biggest expense after retirement, yet people are hesitant to save because they don’t know the 529 Plan rules. A 529 College Savings Plan is a terrific wealth building investment for families and has more benefits and flexibility than people realize. While I think investors need to prioritize their own retirement and wealth management, that time horizon is much longer than for college. Retirement accumulation takes 40 years and then will be spent over 20-30 years. College saving is 18 years or less and then 4-6 years of spending.

College costs are growing faster than CPI and it already costs $300,000 for four years at most private universities. If your student changes majors, or decides to stay for a graduate degree, their cost could reach $500,000. 44.7 million American have student loan debt, totaling over $1.6 trillion. Students loans are a looming crisis; 11.1% are presently delinquent or in default and repayment is crushing a lot of Millennials. Many of us had student loans when we were younger, but do not fully appreciate how the magnitude of these loans have grown since we were in college.

Yes, there are a few drawbacks to College Savings Plans, and that’s why I want you to understand the 529 Plan rules. The value is so significant that when people get hung up on the rules, I think they risk missing out on substantial tax benefits and investment opportunities. After all, there are rules for 401(k) accounts and Roth IRAs, but most people are happy to navigate those rules to reap the rewards.

Tax Rules of 529 Plans

  1. The primary benefit of a 529 Plan is tax-free withdrawals for qualified higher educational expenses, such as tuition, room and board, and books. You can now also use a 529 Plan towards private K-12 tuition, up to $10,000 a year. You can also use $10,000 towards student loan repayment.
  2. There is no Federal tax deduction for 529 Plan contributions, however, many states do offer a state income tax deduction. In some states, you have to contribute to that state’s plan to get a deduction. In other states, you can contribute to any plan. For Texas, there is no state income tax, so there is no deduction for a 529 plan contribution.
  3. Contribution limits: most plans have very high limits, often $350,000 or higher. However, most donors want to stay under the annual gift tax exclusion of $15,000 per person. The IRS will let you contribute 5 years at once, or $75,000 per beneficiary. If you and your spouse are funding a 529, you can each contribute $75,000 or $150,000 total under the gift tax exclusion. If you want to contribute more than that, you can. You just have to file an annual gift tax return. You will not owe any taxes until your gifts exceed your unified lifetime exemption of $11.58 million (2020). (Note: certain candidates propose to lower the estate tax threshold to $3.5 million. If that happens, you may want to exceed the gift limits now to reduce a future estate tax liability.)
  4. All 529 Plans offer tax-deferred growth, so you pay no taxes on interest or capital gains annually. Now the part that stops everyone in their tracks: non-qualified withdrawals are subject to income tax and a 10% penalty.

Tax/Penalty Only on Earnings

Let’s dissect that a bit more, because it’s not as bad as you might think. The income tax and penalty apply ONLY to the earnings portion, not the whole withdrawal. For example, if you contributed $50,000 to a 529 and it grew to $70,000, you would have $20,000 in earnings. Withdraw the whole $70,000 for a non-qualified reason and you would pay a $2,000 penalty and the $20,000 earnings would be treated as ordinary income. At the 24% tax bracket, you’d pay $4,800 in income taxes.

Withdrawals are pro-rata, meaning earnings are proportional for each distribution. A non-qualified withdrawal from a 529 plan is not subject to the 3.8% net investment tax (the Medicare surtax), if you earn over $200,000 single or $250,000 married.

Ways Around the Penalty and Tax

Everyone is frozen by the thought they might have to pay a penalty, but there are exceptions and ways to avoid it. Here are more 529 Plan rules to know:

  1. If the beneficiary dies or becomes disabled, the 10% penalty is waived. If they receive a scholarship, the penalty is waived. Earnings are still taxable, but no penalty.
  2. You can change the beneficiary to another child, grandchild, other relative, or even yourself. If they can use the money for higher education, you’re back to tax-free withdrawals. If you have two or more children or grandchildren, I think it’s pretty likely that someone in your family is going to be able to use the money.
  3. Kid not going to college? You can do nothing and wait. Just because they turned 18, you don’t have to withdraw the money. It never becomes their money and you never lose control of the funds. You can keep it deferred for as long as you like. Maybe they later go to trade school or an apprenticeship program. That’s a qualified 529 expense. Or maybe they have kids of their own down the road. Now you have a college account for your grandkids.
  4. You can give the money to your kid if you want. The taxes are payable to the distributee. Have the 529 distribute the money to your kids and they will owe any tax and penalty on the gains. (And they may be in a lower tax bracket than you. So, this is good tax planning, not being selfish on your part.)
  5. For long-term care. Let’s say your kids don’t use the money and you don’t have grandchildren and this account sits there for decades just growing tax-deferred. If you become disabled you can change the beneficiary to yourself and receive the disability waiver on the penalty.

More Benefits of a 529 Plan

  1. A 529 remains the property of you, the owner. If you instead funded and UGMA or UTMA, that becomes the property of the beneficiary at the age of majority (18 or 21; 21 in Texas). UGMA equals You Give Money Away. They can spend it on anything they want, including whatever terrible decisions you can imagine. No one is thinking this is possible when someone is three, but you give up all your control with an UGMA.
  2. Creditor Protection. Are you a business owner, doctor, or professional worried about getting sued? 529 Plans are creditor protected.
  3. Financial Aid. A 529 plan is a parental asset, subject to a 5.6% expected family contribution from the FAFSA financial aid process. Put that asset in the child’s name and the expected contribution is 20% a year. A 529 plan in the grandparent’s name is not reportable on the FAFSA.
  4. A 529 Plan will not be part of your taxable estate. You can and should name a successor trustee/owner of the funds for after you pass away. As such, 529 plan could be an important way to create a legacy for your family.

It’s Your Family’s Future

If you like the idea of Tax-Free Growth, a 529 Plan could benefit your family. When people get too worried about the 10% penalty and the other 529 Plan rules, they are often paralyzed to take action. Investors contribute to 401(k)’s and Roth IRAs that have a 10% penalty, but they seem to think that with a 529 it’s going to be worse. To get the best tax benefit from a 529, you want to start as early as possible. Opening a 529 plan for a 17 year old going to college in the Fall does not leave you much time for tax-free growth.

Parents and Grandparents want their children have the same opportunities they had. Many would like for their kids to go to the same or better university than they attended. Let’s start with estimating what four years would cost and what it would take to fund that expense monthly starting now.

Don’t have kids yet? Open a 529 Plan in your own name. When your child is born, you can change the beneficiary to their name. We can fund a 529 with a lump sum, or you can set up small monthly contributions. Expenses on 529 plans have been declining in recent years and many offer low-cost index based investment options. You have daily liquidity, however, most plans restrict you to two trades a year to discourage market timing. Almost all plans offer age-based funds, which adjust to become more conservative as a beneficiary approaches college age.

I hope to make it easy to understand the 529 Plan rules, so you can get started. Please don’t hesitate to email me with your questions, I’m here to help.

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10 Questions Grandparents Ask About 529 Plans

Posted On July 7, 2014 By Admin In College Savings /   1 Comment

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It’s summer break and your little grandchildren are one year closer to college. Still haven’t set aside any funds for their college expenses? For grandparents who have the means to help with future college expenses, the 529 College Savings Plan is a tremendous tool. Here are the Top 10 questions grandparents ask about 529 plans.

1) What are the tax benefits of 529 Plans?

Many states offer a state income tax deduction for contributions to a 529 plan. There are no federal tax deductions for 529 contributions, however, withdrawals for qualified higher educational expenses are tax free, so any future gains would be tax-free. The earlier you establish a 529, the greater potential growth you may have in the account. And the greater the potential tax savings!

2) Which 529 plan should I choose? 

The first step in choosing a 529 College Savings Plan is to determine if there is any benefit or incentive to using the “in-state” plan. For example, if you are a New York resident, you can deduct up to $5,000 off your NY state income tax return if you participate in the New York 529 plan. For married couples, you can deduct up to $10,000 per year. The NY deduction is per tax-payer, not per beneficiary. However, in other states, the tax deduction may be per beneficiary and may even carry forward to future years.

In states without an Income Tax, such as Texas and Florida, there are no tax benefits or credits for using the in-state plan, so you can choose from any plan in the country. You might choose a plan with very low costs and a good selection of investments. The rules vary by state, so you will want to look up this information on www.savingforcollege.com.

3) What expenses can you use a 529 Plan for?

529 plan distributions for Qualified higher educational expenses are tax-free. These qualified expenses include tuition, fees, books, lab supplies, computers, and room and board. If your student lives off campus, you are limited to the same amount of expenses that they would have had for living on-campus. You cannot take a qualified 529 Plan distribution for transportation, student loan costs, health insurance, sports/clubs, or other expenses.

4) Are there limits to 529 contributions? 

Contributions to a 529 Plan are considered a gift by the IRS and are subject to gift tax rules.  For 2023, the annual gift tax exclusion is $17,000 per beneficiary. However, 529 Plans have a special exception to this rule which allows you to fund five years of contributions in one year, or $85,000 per beneficiary ($170,000 per beneficiary if funded by a married couple).

Most parents and grandparents try to keep 529 contributions within the Gift Tax exclusion amounts. However, you can contribute more than this amount if you want. But, you will have to file a gift tax return and use up a portion of your unified lifetime exemption.

5) How do assets in a 529 plan impact my estate planning and eligibility for Medicaid? 

Assets in a 529 plan are excluded from your taxable estate. If you are likely to be subject to the estate tax, 529 plans are a terrific tool to shelter assets from the estate tax while maintaining control of those funds. If you have funded five years in advance, and do not survive the five years, the donor’s estate will have to add back a pro-rata portion of the 529 contribution to the taxable estate.

Medicaid rules vary by state. 529s may be counted as assets in some states and may be subject to “look back” provisions by Medicaid. If you are thinking you will become so impoverished to qualify for Medicaid (not Medicare), you might not be the best candidate to be giving money to a 529 Plan.

6) How do 529 plans affect students’ eligibility for financial aid?

Grandparents’ assets are not disclosed on the Federal financial aid application (the FAFSA), so student financial aid eligibility is actually improved compared to having those same funds held in either the parents’ or student’s name. Taking a distribution, however, from the 529 plan is considered reportable income on the FAFSA, so the best time to use the grandparents’ 529 is in the student’s final year of college. The CSS has different rules, so you also have to know which process your university will use for determining financial aid.

7) What if my student doesn’t need the 529 Plan?

If your student doesn’t use the full 529 plan, you have a lot of options. Thankfully, there is no expiration date or time restriction on a 529 account. You can change the beneficiary to another relative, or even save it for future grandchildren. Your beneficiary can also use $10,000 (lifetime) from the 529 to repay student loans. These options all retain the full tax benefits of the 529 Plan.

There are several exceptions to the 10% Penalty. This means you could take a withdrawal, and the gains would be taxable income, but the 10% Penalty would be waived. These situations include: receiving a scholarship, attending a US Military Academy, or the disability or death of the beneficiary.

8) Can 529 plans be used to help pay for private high schools? 

Yes, after the Tax Cuts and Jobs Act (TCJA) 529 plans were expanded to be usable for private elementary and high school tuition. This is limited to $10,000 per year. But be careful, a handful of states will consider this use a taxable distribution (including CA, CO, HI, IL, MI, MN, MT, NE, NY, OR, and VT).

9) What if I end up needing the money in a 529 plan for my own expenses?

Since you control the assets in a 529 Plan, you can make a withdrawal at any time. A 529 plan is revocable by the owner. However, if the withdrawal is taken for a reason other than a qualified higher educational expense, any gains would be subject to income tax and a 10% penalty. Note that the tax and penalty apply only to the gains, not to your principal. If you have multiple 529 accounts, select the one with the lowest gains if you need a withdrawal, and then you can change the beneficiaries on the remaining accounts as needed. Otherwise, all non-qualified distributions are considered a pro-rata distribution consisting of both principal and earnings (like an IRA, there is no FIFO or principal first rules).

10) When does it make sense to pay for college tuition directly or give the money to my child or grandchild to pay for tuition instead of opening a 529 plan?

If a student is within a year or two of college, you may not see sufficient growth in a 529 account to receive much of any tax benefit.  529s are much more attractive when funded at an early age to allow for many years of growth.

While 529 contributions are subject to the gift tax rules, those limitations do not apply to payments made directly for education or medical expenses. If the expenses are greater than the gift tax exclusion amounts, it may make sense to pay college expenses directly, rather than choosing to file a gift tax return and use up part of your lifetime unified exemption. Money given directly to your children or grandchildren will be reported on the FAFSA, which could increase their expected family contribution and potentially reduce their eligibility for other sources of financial aid. It would be preferable to pay the college tuition bill directly rather than giving money to your children or grandchildren.

If you have questions on 529s or college planning, feel free to drop me an email. I am here to help.

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