Utilizing the benefits of a 529 tax plan

The colloquially named “529 tax plan,” or Qualified Tuition Program, is a useful and common method for families seeking to save for future college expenses.  It is important to understand what kinds of income and programs qualify under the Internal Revenue Service’s Section 529 because of the unique value of 529 tax plans. 

Specifically, taxpayers can set aside money for “qualified higher education expenses,” which generally includes tuition, fees, books, supplies, and equipment needed for students enrolling at an “eligible higher education institution.”  The U.S.  Department of Education provides a list of such institutions. 

There are two different types of 529 plans, prepaid tuition plans and college savings plans.  Each offers a different kind of benefit to the taxpayer, but neither has any income restrictions.  Prepaid tuition plans allow a guaranteed, locked-in tuition rate for in-state public colleges at the prices offered at the time the taxpayer signs up for the plan.  Since many colleges increase their tuition every year at least at the rate of inflation, locking in rates far in advance of utilizing them could save tens of thousands of dollars throughout a student’s time in college.  College savings plans offer greater flexibility, but not the same guaranteed rate.  They offer tax-exempt savings vehicles which are investments that are subject to market conditions.  While this plan may offer greater risks, it also sometimes produces greater returns, depending on the market. 

Prepaid tuition plans are guaranteed to increase in value every year because the savings increase with the rate of college tuition.  These plans are appealing to many taxpayers because of how simple they are.  The taxpayer secures the current tuition rate and generally enjoys a better investment than they would otherwise get with bank savings accounts.  Because the plan is locked-in and does not vary with the market, there is no risk to the principal amount for which the investor signed up.  If a taxpayer purchased half of a college’s tuition, they will always have half the college’s tuition rate paid off. 

The tuition guarantee only extends to in-state public college tuition rates.  Should a student instead attend a private school or an out-of-state college, the plan only covers the average of in-state public college tuition.  These plans generally do not require that an individual be a state resident when purchasing the shares.  As such, family members not living with the student, such as grandparents or other extended family, are able to buy shares as an educational gift.  Because states operate the prepaid tuition plans, favorable tax status is sometimes limited to the state’s plan.  Oftentimes, however, state, and local income taxes do not apply to these plans, and prepaid tuition plans are exempt from federal income taxes. 

The account owner maintains control of the plan, allowing them to transfer it to another student should the original individual decide not to go to college or be unable to utilize it for any other reason.  One downside to the plan is that that it has a negative impact on eligibility to student financial aid, but for families that are middle-income or higher-income and may not be receiving much need-based aid anyway, they are often a good option. 

A contribution to a 529 Plan does not qualify for the unlimited gift tax exclusion from federal income taxation for money used to pay educational expenses.  For federal gift tax purposes, a contribution to a 529 Plan is treated as a completed gift of a present interest to the designated beneficiary.  This should be kept in mind if a donor intends to make other gifts during a year to the beneficiary.  The contribution to a 529 Plan will qualify for the annual federal gift tax exclusion which, for 2023, is $17,000.  If the contribution is joined in by a spouse and a gift tax return is filed, the exclusion could cover a $35,000 contribution.  A contribution to a 529 Plan can also be spread forward ratably over five years to avoid gift tax imposition.

College savings plans are also tax-exempt, but they do not include the negative impact on need-based financial aid eligibility, unlike prepaid tuition plans.  As stated previously, however, they also do not lock in rates or offer any tuition guarantees.  Because these plans adapt to market conditions, savings may not be substantial enough to fully cover the costs of higher education, but they also sometimes offer greater returns.  The plans start with an aggressive asset allocation strategy when the child is younger, and steadily become more conservative in investments when the student is closer to the age for attending college.  Like with prepaid tuition plans, the money is controlled by the account owner and not the student. 

These plans allow anyone to contribute on behalf of a student.  While the totality of the gifts to the plan may not exceed the required amounts for attending college, there are no other limitations on contribution amounts.  Many states have limitations of around seven years of post-secondary education so that undergraduate and graduate schools may be covered.  It should be noted that some states do limit both kinds of plans to undergraduate schools. 

Investments in college savings plans are most often exempt from federal, state, and local taxes, though an investor does need to pay at least federal income taxes and potentially an additional 10% tax penalty if they cancel the account and get a refund.  Some states and localities have similar requirements.

It should be noted that every state and the District of Columbia also offer state versions of the 529 plan.  Several hundred private colleges offer an Independent 529 plan as well, which is a national prepaid tuition plan for attendance at such schools.  These plans were introduced in 2004, allowing individual educational institutions to also offer a prepaid tuition plan.

In 2018, the IRS and Department of the Treasury issued three new regulations to 529 tax loans.  One such regulation is from the Protecting Americans From Tax Hikes Act, which added a rule for the 529 beneficiary who receives a tuition refund.  Students sometime receive such refunds if they drop a class mid-semester.  Under the regulation, these funds are not taxable as long as the student redeposits the funds within 60 days.  Another regulation is allowing rollover funds from the 529 plan to be transferred into an ABLE account, which is a tax-favored account for people who become disabled before age 26.  These accounts allow families to save for expenses related to the individual’s disability. 

Perhaps the greatest change that came with this series of regulations is allowing 529 plans to be used for K-12 education rather than only undergraduate or graduate degrees.  Individuals may now use up to $10,000 of tuition per child each year at an elementary or secondary school of the beneficiary’s choosing with this new regulation.  Before enrolling in a 529 plan, investors should carefully review any applicable fees and expenses related to the plan.  Prepaid tuition plans sometimes charge an enrollment or application fee and also sometimes include ongoing administrative fees.  College savings plans may have the same kind of fees as well as annual account maintenance fees, ongoing asset management fees, and ongoing program management fees.

With contribution from Angela Mauroni, second year J.D. candidate at the University of Pittsburgh School of Law.

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