In this week’s post, I explain the basics of a 529 plan.
The cost of education has grown tremendously over the last several decades. The total cost of attendance of many in-state colleges is now more than $30k per year. It’s no wonder that so many students have resorted to student loans – I mentioned in a post several months ago that total student loan debt was $1.7 trillion.
Given the excessive cost of education, families and individuals need to plan ahead. I believe that this planning should encompass several different areas, including saving and investing for education expenses. One way to save is through a 529 plan, which is a special type of account that provides certain tax benefits when saving for education expenses.
As we have continued to emphasize, keep in mind that the type of investment account is distinct from the account’s investment holdings, as we covered in a previous post. The account has its own rules and tax treatment independent from the investments held within the account. This post will explore some of the account-level rules and tax treatment for a 529 plan.
529 plans provide certain tax benefits to people saving for education expenses
529 plans or officially, “qualified tuition programs,” are sponsored by individual states. However, savers can sometimes participate in an out-of-state plan.
There are different types of 529 plans, mainly: prepaid tuition plans and savings plans. Prepaid tuition plans allow savers to pre-pay for a student’s tuition, whereas savings plans allow savers to accumulate funds in an account to help pay for education expenses. Only a handful of states still offer prepaid tuition plans, so this post will focus on savings plans.
When setting up a 529 plan, the owner designates a beneficiary, who is the future student. However, the designated beneficiary can be changed to a different person. If the designated beneficiary is changed, there can sometimes be tax consequences, depending on how the new beneficiary is related to the prior beneficiary.
A 529 plan provides certain tax benefits to people saving for education expenses. In summary, a 529 plan is funded with federally after-tax dollars (no federal tax deduction is available). However, all growth in the account is tax-free and all qualified withdrawals are tax-free. Certain state tax deductions may also be available.
How much can be contributed and how are contributions taxed?
There is no yearly limit on the amount that can be contributed to a 529 plan. However, there are total contributions limits that vary by state. For example, Virginia has a total contribution limit of $550,000 per beneficiary. This is different than some other types of accounts, such as traditional IRAs and Roth IRAs, that have yearly contribution limits.
Even though there are no yearly limits, 529 contributions are considered gifts to the beneficiary. Gifts above the annual exclusion amount will require a gift tax return and potentially gift taxes being paid – although gift tax can usually be avoided, because of the current lifetime gift/estate tax exemption amount. The annual gift exclusion amount in 2022 is $16,000 per donor for every recipient – the amounts are aggregated for all gifts to that recipient throughout the year. For example, a $10,000 contribution to a 529 plan and a $10,000 cash gift would aggregate to a total gift of $20,000 for the year – a gift tax return would have to be filed, because this is over the $16,000 annual exclusion amount. Married couples can split gifts, doubling the $16,000 annual exclusion limit to $32,000. Gift splitting requires a gift tax return to be filed. There is also a special rule that allows for five years of 529 contributions ($80k per donor, $160k per couple) to be made at one time without gift tax consequences, but a gift tax return still has to be filed. Gift taxes can get complicated and will likely be the subject of a future post.
Funds contributed to a 529 plan are not deductible for federal incomes taxes. However, certain states do allow for state income tax deductions for 529 contributions. For example, a Virginia resident making contributions to a Virginia 529 plan can receive a state tax deduction for a contribution, up to $4,000 per account (there is no limit if the account owner is 70+ years old).
Are investment earnings taxed?
Investment earnings in a 529 plan are not taxable, so the account grows tax-free.
When can withdrawals be taken and how are they taxed?
In order to be tax and penalty free, withdrawals must be used for qualified education expenses at an eligible educational institution. Eligible expenses include tuition, books and supplies, and room/board (with some limits). Eligible institutions include most colleges and private grade schools. Historically, 529 plans have been used to pay for college expenses, but they can also now be used for K-12 expenses, up to a $10,000 limit per year for each beneficiary. In addition, up to $10,000 of student loans can be paid off using from a 529 plan – this is a lifetime limit, not a yearly limit. If withdrawals are taken in excess of qualified expenses, taxes and penalties will be owed (with some exceptions).
Example of a 529 plan
Beth contributed $16,000 this year to a 529 plan for the benefit of her newborn daughter, Lydia. Because the gift is within the annual gift tax exclusion, a gift tax return does not have to be filed. The contribution is not deductible against her federal taxes, however $4,000 is deductible on her state return, because she lives in Virginia. This will reduce her state taxes by $230 ($4,000 * 5.75%).
If this $16,000 grows at 6% a year for 18 years (around the time Lydia is about to go to college), there will be $45,669 in the account. During this period, all investment gains are tax-free. If all distributions are used for qualified education expenses, no tax or penalties will be owed.
Here is a visual:
If you have any comments, questions, or ideas for future posts, please let me know
I hope you found this post helpful and educational. If you have any comments, questions, or ideas for future posts, please let me know. You can reach me directly via email at crawford@ulmerfinancial.com.
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