Consider the Benefits of Saving for Education Expenses with a 529 Plan

There are many ways to save (and later pay) for education. One popular way is the creation of a qualified tuition program account known colloquially as a 529 Plan from the section of the Internal Revenue Code (IRC) defining its tax attributes. There are two types of 529 Plans. This article focuses on those that allow a person to make contributions to an account (an Account) in a program established by a state (or state agency) for the purpose of paying the account beneficiary’s higher education expenses to an eligible educational institution (which can also include certain payments to elementary and secondary schools, whether a private, public or parochial).

Income Taxes

Families can accumulate funds in a 529 Plan to pay qualified higher education expenses, as defined in the IRC, for their members. Funds in a 529 Plan can grow without the imposition of a current income tax and, when withdrawn, are not subject to income tax if used to pay qualified higher education expenses of the designated beneficiary (and in a certain case, siblings of the designated beneficiary). Earnings on funds withdrawn from a 529 Plan that are not used to pay qualified higher education expenses are subject to regular income tax and, subject to exceptions, a 10% additional tax, referred to herein as a penalty. (Income tax and penalty are not imposed on the portion of an Account withdrawal that represents original contribution amounts).

Certain distributions not used for qualified higher education expenses are not subject to the 10% penalty. These include the following payments:

• To the designated beneficiary or to the deceased beneficiary’s estate, after the beneficiary’s death.
• To a beneficiary that suffers a physician-certified disability that substantially limits gainful activity and that is expected to be long-continued, of an indefinite duration or result in death. 
• To a beneficiary who received a tax-free scholarship or fellowship grant up to the amount of that scholarship. 
• To a beneficiary who received educational assistance through a qualifying employer program up to the amount of the benefit received.
• To a beneficiary who received educational assistance through a qualifying veterans’ educational assistance program up to the amount of the benefit received.
• To a beneficiary attending a U.S. military academy, but only to the extent that the amount doesn’t exceed the costs of advanced education attributable to such attendance.
• To the extent the funds are included in income to claim another educational tax benefit, such as the American opportunity tax credit, lifetime learning credit or tuition and fees deduction.

Qualified Higher Education Expenses

A 529 Plan is designed to accumulate funds to pay qualified higher education expenses. Qualified higher education expenses for a designated beneficiary include:

• Tuition, fees, books, supplies and equipment required for the enrollment or attendance at an eligible educational institution. 
• Expenses for special needs services in the case of a special needs beneficiary which are incurred in connection with such enrollment or attendance. 
• Expenses for the purchase of certain computer or peripheral equipment, computer software or internet access and related services, if such equipment, software or services are to be used primarily by the beneficiary during any of the years the beneficiary is enrolled at an eligible educational institution; but does not include expenses for computer software designed for sports, games or hobbies unless the software is predominantly educational in nature. 
• Up to $10,000 per beneficiary per year to pay tuition for grades K through 12. 
• Up to $10,000 of qualified student debt per beneficiary (or sibling of the beneficiary). 
• Certain expenses for room and board for beneficiaries enrolled at least half-time at an eligible post-secondary education school. 
• Certain expenses, fees, books, supplies and equipment required for participation in an apprenticeship program registered and certified with the Secretary of Labor under section 1 of the National Apprenticeship Act.

Funding a 529 Plan

A 529 Plan is funded with after-tax cash contributions to a beneficiary’s Account. For gift tax purposes, contributions to a beneficiary’s Account are treated as completed gifts to the beneficiary that are not gifts of a future interest in property. This allows the contribution to be eligible for the annual exclusion from federal gift tax treatment.

A 529 Plan has a special benefit that allows a donor to “frontload” the plan with five years’ annual exclusion amounts. Frontloading a 529 Plan allows a significant amount to be invested right away, permitting income tax-free income and growth on a significant principal base to begin immediately. However, fully frontloading a 529 Plan consumes the donor’s annual exclusion for making gifts to or for the Account beneficiary in the year of funding and for the next four years. Therefore, unless the annual exclusion amount increases as a result of indexing for inflation, after fully funding a 529 Plan Account for a beneficiary, a future gift to or for that beneficiary in the year of funding or the following four years would be a taxable gift that would either consume lifetime gift tax exclusion or require the payment of a gift tax.

To frontload a 529 Plan Account, the donor must make an election on the federal gift tax return for the year of the transfer. If the election is made, the amount contributed to the 529 Plan up to five times the annual exclusion amount in the year of funding, may be taken into account ratably over five years. Any amount over five times the annual exclusion amount for the year of funding is a taxable gift in that year. If the annual exclusion amount is later increased due to indexing for inflation, additional amounts may be contributed to the 529 Plan in such later years (up the increased annual exclusion amount).

If the donor frontloaded a 529 Plan and dies before the expiration of five years from funding, the portion of the funding allocated to years beginning after the donor’s death is included in the value of the deceased donor’s gross estate (and potentially subject to federal estate tax).

A 529 Plan Account may not be funded with contributions in excess of those necessary to provide for the qualified higher education expenses of the qualified beneficiary. This amount varies from state to state.

Restricted Investments

A 529 Plan may only accept cash contributions. As a practical matter, cash contributed to a 529 Plan may only be invested in mutual funds offered by the Account manager. A donor to a 529 Plan or the beneficiary may only change investments twice in any calendar year.

It is possible to move funds in a beneficiary’s Account from one 529 Plan to another without income tax, penalty or gift tax (known as a rollover). To complete a rollover, funds distributed from the beneficiary’s original 529 Plan Account must be contributed to a new 529 Plan Account for the same beneficiary within 60 days of the distribution from the first Account. A rollover may be made only once in any 12-month period.

Funds Remaining

It is not possible to know in advance how much an Account beneficiary’s education will cost. It is possible that more funds will be accumulated in a 529 Plan than will be needed to pay for its beneficiary’s education.

What can be done with funds remaining in a beneficiary’s 529 Plan Account if that beneficiary will have no further higher education expenses?

• Change Beneficiaries: The beneficiary of a 529 Plan Account may be changed to another person. Such a change will be considered a distribution from the 529 Plan unless the new beneficiary is a “member of the family” of the old beneficiary.
  With respect to any designated beneficiary a member of the family is:
  • (i) the spouse of such beneficiary; 
  • (ii) the beneficiary’s child or a descendant of a child; the beneficiary’s brother, sister, stepbrother, or stepsister; the beneficiary’s father or mother, or an ancestor of either; the beneficiary’s stepfather or stepmother, a son or daughter of a brother or sister of the beneficiary; a brother or sister of the father or mother of the beneficiary; a son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, or sister-in-law of the beneficiary; 
  • (iii) the spouse of any individual described in the preceding clause (ii); and any first cousin of the beneficiary. Changing a beneficiary may be subject to federal gift tax and generation-skipping transfer (GST) tax unless the new beneficiary is a member of the family of the old beneficiary and is assigned to the same (or higher) generation as the old beneficiary for GST tax purposes.
     
• Rollover to the 529 Account for a Different Beneficiary: The balance in the old beneficiary’s account may be rolled over to an existing 529 Plan Account for a different beneficiary. To qualify as a rollover, the beneficiary of the receiving Account must be a member of the family of the beneficiary of the old Account. Rules similar to those described above for same beneficiary rollovers apply. Also, the rollover may be subject to the federal gift tax and GST tax unless the new beneficiary is a member of the family of the old beneficiary and is assigned to the same (or higher) generation as the old beneficiary for GST tax purposes.
  
  
• Rollover to an ABLE Account for a Disabled Beneficiary: Before January 1, 2026, some or all of the Account may be rolled over to an ABLE account for a disabled person. To avoid being treated as a distribution, the amount distributed must be rolled over within 60 days and the beneficiary of the ABLE account must be the original beneficiary of the 529 Plan Account or a member of the family of such beneficiary. Any amount rolled over in excess of the annual contribution limit for an ABLE account (taking into consideration prior contributions to the ABLE account for such year) will not qualify for rollover treatment. Also, the rollover may be subject to the federal gift tax and GST tax unless the new beneficiary is a member of the family of the old beneficiary and is assigned to the same (or higher) generation as the old beneficiary for GST tax purposes.
  
  
• Pay Qualified Student Debt: A 529 Plan can be used to repay up to $10,000 of qualified education loans per beneficiary (or sibling of the beneficiary). The term “qualified education oan” means any indebtedness solely to pay qualified higher education expenses of the beneficiary (or sibling of the beneficiary), incurred by the beneficiary, the spouse of the beneficiary or a parent of the beneficiary (if the beneficiary was a dependent of the parent at the time the indebtedness was incurred). The term does not include debt to a related party or debt to a qualified employer plan.
  
  
• Rollover to Roth IRA Account: Under certain conditions and subject to specific limitations, a tax- and penalty-free rollover of a long-term 529 Plan Account is allowed by its designated beneficiary to a Roth IRA for that beneficiary. A beneficiary of a 529 Plan may roll over up to $35,000, in the aggregate, from a 529 Plan account to a Roth IRA (for their own benefit). Rollovers to a Roth IRA can be made from a 529 Plan Account for such beneficiary that has been open for at least 15 years and are subject to the Roth IRA annual contribution limit. For this purpose, the Roth IRA income limitation for contributions is waived.