The cost of tuition and related costs are continuing to rise at a greater pace than the rate of inflation, with Ivy League schools now priced at more than $50,000 per year. Families that want to save for higher education costs on a tax-advantaged basis can look to 529 savings plans. These are state-run programs in which contributions are invested; the funds available for education depend on the amount contributed and how well they are invested. The particulars of the plan vary from state to state.
During the economic turndown, these savings plans, like other Wall Street investments, were very disappointing. Some contributors lost money through their investment in their 529 plan. Now that the stock market has improved, interest in 529 savings plans has also returned. Here are tax rules related to these plans.
Tax breaks
Contributions to 529 savings plans do not entitle the contributor to any federal tax deduction or credit (Code Sec. 529). Despite the lack of deductibility, the plans offer other significant tax breaks.
1. Contributions may entitle contributors to a state-level tax break to reduce state income taxes. For example, New York allows residents who contribute to the state’s 529 plan (https://
uii.nysaves.s.upromise.com/) an annual deduction of up to $5,000 per contributor (which effectively is $10,000 for a married couple).
2. Earnings on contributions are not taxed annually. They continue to grow on a tax-deferred basis.
3. Withdrawals to pay qualified education expenses are tax free to both the contributor and the beneficiary of the account. Qualified expenses include tuition, fees, books, supplies, and equipment required for enrollment or attendance at an eligible institution (usually a school eligible to offer federal financial aid).
4. Room and board are also treated as eligible expenses as long as the beneficiary is at least a half-time student.
5. Computers and technology, which were qualified expenses in 2009 and 2010, are no longer treated as qualified expenses.
6. If funds are withdrawn by the account owner or the beneficiary for non-qualified purposes, the earnings are taxed to the person who makes the withdrawal. Moreover, there is a 10% penalty, regardless of age of the person taking the withdrawal.
7. Withdrawals are taxed according to the rules applicable to annuities (Code Sec. 72), so that a part of the withdrawal is viewed as taxable earnings while the balance is a nontaxable return of the contributor’s investment (which was made with after-tax dollars).
Contribution limits
8. Federal income tax law does not set a dollar limit on annual contributions to 529 savings plans. Instead, the maximum amount is determined by state rules for their 529 plans. Each state sets the limit on the value that an account can have; contributions can be made to meet this limit. The limit can be adjusted each year. Examples of contribution caps in 2012:
- California: $350,000 per beneficiary
- Florida: $382,000 per beneficiary
- New York: $375,000 per beneficiary
- Texas, $370,000 per beneficiary
9. The limit applies per beneficiary, so if there are multiple accounts for the same student, the values of all accounts for a beneficiary must be combined to see whether the cap has been met. It would appear that this cap can be avoided by setting up accounts in different states for the same beneficiary. The need to do so is remote because the annual caps set by the states are designed to keep pace, more or less, with the cost of higher education.
Coordination with other education-related tax rules
10. The amount of qualified higher education expenses covered by 529 plan withdrawals must be reduced by tax-free assistance (e.g., scholarships, Pell grants, employer-paid education assistance, or veteran’s assistance). If a parent (or student) claims the American Opportunity credit (Code Sec. 25A(i)) or Lifetime Learning credit (Code Sec. 25A(c)) for qualified education expenses, then the expenses taken into account for the credit cannot also be used to determine tax-free withdrawals from the 529 plan.
11. If, in the same year, distributions are taken from a 529 plan and a Coverdell ESA, then qualified expenses have to be allocated between the two plans. The allocation is based on the relative size of the withdrawals.
Unused funds
What happens if the beneficiary chooses not to go to college or fails to use up all the funds? The owner of the account has options about what to do:
12. Do nothing and let the funds grow. The beneficiary may want to pursue more higher education, such as a graduate degree, in the future. There is no age limit for a beneficiary. Unlike Coverdell ESAs (Code Sec. 530), which require funds to be distributed by age 30 in most cases, there is no similar distribution requirement for 529 plans.
13. Name a new beneficiary. As long as the new beneficiary is a member of the family of the old beneficiary, the change is not treated as a distribution (Code Sec. 529(c)(3)(C)). Thus, the new beneficiary can be a sibling, cousin, or even the beneficiary’s child. There are no tax consequences to the contributor or the beneficiaries for making this change.
14. Withdraw the funds and pay the tax bill, plus the penalty, related to the earnings on your contributions. There may also be recapture of any state income tax breaks that the contributor previously enjoyed.
Making and changing investments
15. Each state’s plan offers a menu of investment options. Check these options as well as the fees and other expenses in these plans to select the best options. Most states permit out-ofstate contributors. However, state-level income tax breaks can be lost unless in-state plans are used.
16. An account owner can change investments. Usually, this is limited to one change per year.
17. If funds are to be moved to another 529 plan, be sure to arrange for a direct transfer. There is no rollover option for 529 plans, as there is for IRAs (see Karlen, TC Summary Opinion 2011-129)). If a check is issued to the account owner, it is taxable, even if the funds are immediately replaced in another 529 account or plan.
Account losses
18. Like IRAs and 401(k) plans, the value in the 529 account can vary from month to month and year to year. Generally, no losses can be claimed by the account owner. However, if the entire account is distributed and the amount of the distribution is less than total contributions, the contributor can take the loss. The loss is treated as a miscellaneous itemized deduction subject to the 2%-of-adjusted-gross-income floor. The loss is reported on Schedule A of Form 1040. If the contributor is subject to the alternative minimum tax, any tax savings as a result of the 529 plan loss is effectively lost forever.
Estate taxes
529 plans offer significant estate planning benefits to contributors.
19. Gift taxes. A contribution to a 529 plan is treated as a completed gift for gift tax purposes and qualifies for the annual gift tax exclusion per beneficiary (Code Sec. 529(c)(2)(A)(i)). This is so even though the owner retains the right to recoup contributions, change beneficiaries, and make investment decisions.
20. Under a special five-year rule, a lump-sum contribution can utilize five times the annual gift tax exclusion ($13,000 in 2012; $14,000 in 2013) (Code Sec. 529(c)(2)(B)). This means a contributor can add $65,000 in 2012, or $70,000 in 2013 without having to rely on any portion of the lifetime gift tax exemption amount; the contribution is fully shielded from tax by the five-year rule for the annual gift tax exclusion. Married couples can double the gift by consenting to make a joint gift.
21. Estate taxes. The value of the assets remaining in the account on the contributor’s death usually is not included in his or her gross estate (Code Sec. 529(c)(4)). However, if the contributor used the special five-year rule to minimize or avoid gift tax on his/her contributions (by averaging them over five years and applying the annual gift tax exclusion accordingly), the value of the account related to the portion of that five-year period that has not yet expired is included in his/her estate.
Conclusion
22. Parents and grandparents of young children can utilize 529 plans to ensure adequate funds will be available to pay their higher education costs. The plans can also be used by wealthy parents and grandparents as part of their estate planning strategies.
Sidney Kess, CPA, J.D., LL.M., has authored hundreds of books on tax-related topics. He is best-known for lecturing to more than 700,000 practitioners on tax and estate planning.
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