With the start of the new school year upon us, it is an opportune time to revisit the basics of a 529 plan and the usefulness these popular plans.
What is a 529 Plan?
A 529 plan is a college saving plan that offers tax and financial aid benefits. With the recent 2018 tax law changes, 529 plans now may also be used to save and invest for K-12 tuition in addition to college costs. There are two types of 529 plan: college savings plans and prepaid tuition plans.
The most commonly referenced and used 529 plan is called a College Savings Plan. They work much like a Roth 401(k) or Roth IRA by investing your after-tax contributions in mutual funds or similar investments. The 529 college savings plan offers several investment options from which to choose. The 529 plan account will go up or down in value based on the performance of the investment options.
Prepaid Tuition Plans let you pre-pay all or part of the costs of an in-state public college education. They may also be converted for use at private and out-of-state colleges. They are not an investment vehicle. A Private College 529 Plan is separate prepaid plan for private colleges. Educational institutions can offer a prepaid tuition plan but not a college savings plan.
What can a 529 plan be used for?
A 529 plan is an investment account that offers tax-free earnings growth and tax-free withdrawals when the funds are used to pay for qualified education expenses. For college, university, and other eligible post-secondary educational institutions, this includes tuition, fees, books, supplies, equipment, computers and sometimes room and board. The IRS also allows tax-free withdrawals of up to $10,000 per year, per beneficiary to pay for tuition expenses at private, public, and religious K-12 schools.
What is not covered by a 529 plan?
The funds in a 529 plan are yours, the owner of the 529 plan, and you can always withdraw them for any purpose. However, the earnings portion of a non-qualified distribution will be subject to ordinary income taxes and a 10% tax penalty. There are a few exceptions where the 10% penalty is waived – the beneficiary receives a tax-free scholarship, attends a U.S. Military Academy, or dies or becomes disabled. Nonetheless, the earnings will still be subject to federal, and sometimes state, income tax.
At the college or post-secondary level, a general rule of thumb is that expenses required for enrollment in an eligible institution are covered. However, there are some costs that one may believe are necessary, but the IRS does not. For example, a student’s health insurance, transportation costs and student loan payments are not qualified expenses.
Then, what IS a qualified education expense?
Qualified expenses include tuition and fees, books and materials, room and board (for students enrolled at least half-time), computers and related equipment, internet access and special needs equipment for students attending a college, university or other eligible post-secondary educational institutions.
The recent Tax Cuts and Jobs Act of 2017 also allows for tax-free distributions up to $10,000 per year, per beneficiary to pay for K-12 tuition expenses at private, public, and religious schools.
Which states offer 529 plans and what are the tax benefits?
Nearly every state now has at least one 529 plan available and it is up to each state to decide whether it will offer a 529 plan, or possibly more than one plan, and what it will look like. What that means is 529 plans can differ from state to state and it is important to compare different state plans especially in terms of investment options and fund costs and fees.
While each state has their own plan(s), investors are not limited to the state they live in or the state that the beneficiary goes to school in. The owner of the 529 plan can live in Colorado, open a 529 plan in Texas, and the beneficiary go to school in New York.
As long as the plan satisfies a few basic requirements, the federal tax law provides special tax benefits, such as 5-year gift tax averaging and tax-free qualified distributions. And while 529 plan contributions are not tax deductible on federal income taxes, over 30 states and the District of Columbia offer state income deductions or tax credits for contributions to 529 plans. However, the investor or owner of the 529 plan may be restricted to investing in their home state’s 529 plan in order to claim the benefit.
What happens if the beneficiary doesn’t go to school or the money in the 529 plan is not used?
As noted above, you can always withdraw from the 529 plan for any purpose. However, to avoid paying taxes and a penalty on your earnings, there are a few options, including:
- Change the beneficiary to another qualifying family member
- Hold the funds in the account in case the beneficiary wants to attend grad school later
- Make yourself the beneficiary and further your own education
- Roll over the funds to 529 ABLE account, a savings account specifically for people living with disabilities
- Or as of January 1, 2018, parents also have the option to take up to $10,000 in tax-free withdrawals for K-12 tuition
Please contact our office if you would like to learn more. We are happy to discuss the specifics in more detail and whether a 529 plan and plan options are right for you.
Source: “What is a 529 Plan?” Savingforcollege.com, July 17th, 2018, https://www.savingforcollege.com/intro-to-529s/what-is-a-529-plan. Accessed 26 July 2018.
