One of the largest expenses a family will incur is very likely the cost of a child’s education. In order to encourage early participation in saving for education expenses, Section 529 of the Internal Revenue Code permits states to provide tax-advantaged savings plans (“529 plans”). A 529 plan account may be used to help pay for a beneficiary’s tuition at an elementary or secondary public, private, or religious school (capped at $10,000 per year). It can also be used to pay higher education expenses, such as tuition, fees, books, supplies (including computers and related equipment), and room and board (on-campus and off-campus housing, with certain limitations), at an eligible higher education institution. An eligible higher education institution is generally any college, university, vocational school, or other postsecondary educational institution eligible to participate in a student aid program administered by the U.S. Department of Education.
An individual may open a 529 account provided under a plan of his or her state. However, some state plans do not require that the account-holder be a resident of the sponsoring state. When a 529 account is opened, the account-holder designates a beneficiary of the account and, if permitted by the state’s plan, a successor account-holder who will manage the account if the initial account-holder dies. The designated beneficiary is usually the student or future student (e.g., a child or grandchild) for whom the account-holder intends to provide benefits. The beneficiary is generally not limited to attending a school in the state that sponsors the plan.
A contribution to a 529 account must be made in cash and is treated as a completed gift to the designated beneficiary for federal gift tax purposes. The funds of the 529 account are invested by the state, or the investment manager selected by the state, generally in a mutual fund. The 529 account balance cannot exceed the expected cost of the beneficiary’s qualified education expenses. Overall limits vary by state, currently ranging from $235,000 to $529,000. Maryland, D.C., and Virginia each set a maximum account balance of $500,000 per beneficiary.
Some of the important tax advantages of a 529 account include:
- No income limits restrict who may contribute to a 529 account.
- A 529 account is exempt from income tax. Therefore, it grows tax-free.
- Many states offer a state income tax deduction for residents who contribute to the state’s plan. Maryland, D.C., and Virginia each provide an income tax deduction to residents contributing
to its plan.
- A contribution to a 529 account qualifies for the gift tax exclusion ($15,000 per beneficiary in 2019).
- A donor may elect to contribute up to five times the annual exclusion amount ($75,000 per beneficiary in 2019) in a single year. When a donor elects to fund an account in this manner, he or she cannot contribute again until year six. This election is made on a federal gift tax return, although no gift tax will be due unless the donor has exceeded his or her federal gift tax exemption amount, $11.4 million for 2019.
- A distribution from a 529 account is not included in the gross income of the designated beneficiary to the extent it is used to pay the beneficiary’s qualified education expenses.
- A 529 account is not included in the account-holder’s estate for estate tax purposes.
Let’s look at an example: Harry and Wanda are married, have one child, Claire, who is age 7, and reside in Maryland. Harry establishes a 529 account and designates Claire as the beneficiary and Wanda as the successor account-holder. In 2019, Harry and Wanda each contribute $75,000 (for a total contribution of $150,000) to the 529 account and each of them files a federal gift tax return to elect to treat the gift as spread ratably over five years ($15,000 each year from 2019 through 2023) with no federal gift tax due. Harry and Wanda will receive a Maryland income tax deduction in 2019 for a portion of their contributions. The contributions to the 529 account will grow free of income tax. When Claire goes to college, neither Claire nor her parents will pay income tax on the distributions from the 529 account that are used to pay for her qualified education expenses.
A 529 account permits the account-holder to achieve these important tax benefits while retaining control of the account. Generally, the designated beneficiary has no legal rights to the funds and the account-holder determines when and to what extent to make distributions for the beneficiary’s qualified education expenses. In addition, generally the account-holder can change the designated beneficiary, without any tax consequences, if the new beneficiary is a member of the same family and in the same generation as the initial beneficiary (e.g., another child, a niece
or nephew). Finally, the account-holder can take back the funds of the 529 account for his or her own personal use or for any other purpose. However, if the account-holder does not use the distribution for the designated beneficiary’s qualified education expenses, the earnings portion of the distribution is subject to income tax and a 10% penalty.
A 529 account can be started at any time. But one of the primary benefits of a 529 account comes from income tax-free growth in the account; these earnings are usually a function of time. So, it is always better to start early.
A valuable online resource for 529 plan accounts is www.savingforcollege.com.