Pros and Cons of 529 Plans

So you want to start saving money for college? With the cost of higher education doubling in the last 30 years, starting to save early is a great idea. Whether it’s for your own kids, grandkids, nieces/nephews, or maybe even your God children, helping a child you love cover at least some of the expenses associated with higher education is an amazing gift. A great option for starting to build an education-specific savings account is a 529 plan. These incredibly popular plans also offer a few tax benefits. 529 plans first came onto the scene in the mid-1980s and originally functioned as a pre-paid tuition account. By the 1990’s, Section 529 (hence the name 529 plan) was added to the Internal Revenue Code, allowing for a tax-free status for certain tuition programs. These accounts grow on a tax-deferred basis (meaning tax isn’t owed on the earnings) and if the recipient makes withdrawals from the account for higher education expenses the withdrawals are not taxed either. Every state has at least one 529 plan available. However, you do not have to invest in a plan in your state or even the resident state of the intended recipient. Additionally, for most plans, the choice of college is not affected by the state that sponsored the plan. Currently more than 6,000 U.S. colleges and universities and 400 foreign colleges and universities will allow students to utilize a 529 plan for tuition and other education expenses.

What expenses are approved? Tuition, room and board, and textbooks were the original expenses included in the plans approved costs. In recent years, the original definition of “higher education expenses” has been expanded to reflect the changing landscape and increasing costs of education. These expenses can now include computers, up to $10,000 annually in k-12 tuition, student loan payments, and even the costs of apprenticeship programs.

What are the tax benefits? From a federal tax perspective, 529 plans offer significant benefit in terms of tax-free growth and tax-free withdrawals. 529 plans can be invested in many ways, such as guaranteed returns and even mutual funds or stock market investments. In a typical investment account, any growth would be considered taxable income. With 529 plans, the accounts can see significant growth and if the withdrawals are made for approved, educational purposes, no tax will be paid on that growth. State-specific tax benefits generally are enhanced or dependent on the plan being an in-state plan (i.e. the state in which the contributor resides and pays income tax). There are a few exceptions to this: Arizona, Kansas, Maine, Missouri, Montana, and Pennsylvania are referred to as tax-parity states and offer income tax benefits regardless of the state plan utilized.

How much money can I invest in a 529 Plan? With the gift tax exemption amount (2020) of $15,000, 529 accounts can be funded in large amounts. This means that a married couple can contribute up to $30,000 ($15,000 per contributor) per child each year without having to file gift tax returns. Better yet, for grandparents with the desire to make a large contribution, a 5 year election rule is in place. This means that grandparents can elect to contribute 5 years’ worth of the gift tax exemption at one time, totaling a contribution of $75,000 all at once. While a gift tax return would have to be filed, the use of the 5 year election has no impact to the overall estate exemption. Unfortunately, there are some funding limitations that do exist. Generally, 529 plans cannot have amounts greater than $235,000 in the plan. However, if the plan does cross that threshold, only contributions need to be suspended.

What if my child doesn’t go to college? In some cases, children opt out of college education or receive scholarships and grants that cover college expenses. In this case, there will unfortunately be a tax bill to be paid if funds are distributed for a non-qualifying expense. Taxes on distributions of that manner include income taxes on the earnings, as well as a 10% withdrawal penalty. To top it off, many states require the tax benefit to be repaid for funds distributed in this manner.

For families with multiple children or qualifying relatives, there could be a much better way. 529 plans allow owners to add beneficiaries even after the account has been funded. By adding a beneficiary, owners can avoid taking taxable withdrawals as well as provide funds to another child or beneficiary. Adding a beneficiary does not cause a taxable event, so no taxes will be due because of the additional beneficiary either.

Questions about 529 plans or other tax planning strategies? Get in touch with our office!