529 College Saving Plans
529 college savings plans, named after section 529 of the Internal Revenue Code of 1986, are among the best ways to save for college, offering advantages from both a tax and financial aid perspective. 529 plans first became available in 1996.
Investments in a 529 plan are made with after-tax dollars. Although contributions to a 529 plan are not deductible on your federal income taxes, many states offer a state income tax deduction or tax credit on contributions to the state’s 529 plan. This makes 529 plans superior to a Roth IRA.
Earnings accumulate on a tax-deferred basis and are entirely tax free if used to pay for qualified higher education expenses.
Non-qualified distributions are taxed at the beneficiary’s rate, plus a 10 percent tax penalty. The taxes and tax penalty are assessed on just the earnings portion of the distribution, which is assumed to be proportional. The portion of the distribution that represents a return of contributions is not taxed.
Even with the 10 percent tax penalty, the total tax liability may be the same or lower than the tax liability associated with saving in the parent’s name in taxable accounts.
There are several exceptions to the 10 percent tax penalty.
- The beneficiary dies or becomes disabled
- The beneficiary receives a tax-free scholarship, veterans education assistance or employer tuition assistance
- The beneficiary attends a U.S. military academy
- Qualified distributions were reduced due to coordination restrictions with the American Opportunity Tax Credit and Lifetime Learning Tax Credit
The 10 percent tax penalty is eliminated on the portion of the distribution corresponding to these exceptions. The earnings remain subject to ordinary income taxes at the beneficiary’s rate.
If the taxpayer lost money on a 529 plan investment, the taxpayer can deduct the losses as a miscellaneous itemized deduction, if they exceed 2 percent of adjusted gross income (AGI) and the taxpayer liquidated the 529 plan. A loss is defined as the refund value being less than the unrecovered basis. Taxpayers can also use losses in one 529 plan to offset gains from other 529 plans.
State Income Tax Benefits
Taxpayers can invest in any state’s 529 plan. Many states offer special state income tax benefits on contributions to the state’s 529 plan. Accordingly, taxpayers should consider both their own state’s 529 plan as well as the 529 plans of states with very low fees (e.g., less than 1 percent).
Three dozen states offer state income tax deductions or tax credits on contributions to the state’s 529 college savings plan:
- Thirty-three states offer a state income tax deduction. These include Alabama, Arizona, Arkansas, Colorado, Connecticut, Georgia, Idaho, Illinois, Iowa, Kansas, Louisiana, Maine, Maryland, Massachusetts, Michigan, Mississippi, Missouri, Montana, Nebraska, New Mexico, New York, North Carolina, North Dakota, Ohio, Oklahoma, Oregon, Pennsylvania, Rhode Island, South Carolina, Virginia, Washington DC, West Virginia and Wisconsin.
- Three states offer a state income tax credit. These include Indiana, Utah and Vermont.
Six of the states provide tax parity, allowing a state income tax deduction for contributions to any state’s 529 plan. These states include Arizona, Kansas, Maine, Missouri, Montana and Pennsylvania.
Contribution limits are high enough in 17 states to yield a significant state income tax benefit. These states include Alabama, Arkansas, Colorado, Connecticut, Indiana, Illinois, Michigan, Mississippi, Missouri, Nebraska, New Mexico, New York, North Dakota, Oklahoma, Pennsylvania, South Carolina, West Virginia.
Some states require the taxpayer to be the account owner in order to claim the state income tax deduction. The 11 states include Iowa, Maryland, Missouri, Montana, Nebraska, New York, Rhode Island, Utah, Vermont, Virginia and Washington DC.
529 plan money may be used to pay for undergraduate and graduate expenses at colleges and universities that are eligible for Title IV federal student aid.
Qualified higher education expenses include:
- Tuition and fees
- Books, supplies and equipment
- Expenses for special-needs services related to enrollment or attendance
- Room and board, if the student is enrolled on at least a half-time basis, but capped at the housing allowance in the college’s cost of attendance or the amount charged for college-owned or operated housing, whichever is higher
Financial Aid Advantages
529 college savings plans provide favorable treatment under federal financial aid formulas. The financial aid treatment is specified in the Higher Education Act of 1965 at 20 USC 1087vv(f).
If the 529 plan is a custodial 529 plan (owned by a dependent student) or if the 529 plan is owned by a dependent student’s custodial parent, it is reported as a parent asset on the Free Application for Federal Student Aid (FAFSA) and distributions are ignored. 529 plans that are owned by a stepparent also are reported as a parent asset for as long as the stepparent is married to the custodial parent.
Parent assets are assessed on a bracketed system, with a top bracket of 5.64 percent of the asset value, after subtracting an asset protection allowance. This has a more favorable impact on eligibility for need-based financial aid than student assets, which are assessed at a flat 20 percent rate with no asset protection allowance.
Assets will be disregarded if the parents qualify for the Simplified Needs Test.
If the 529 plan is owned by anybody else, it is not reported as an asset on the FAFSA, but distributions count as untaxed income to the beneficiary. Untaxed income is treated the same as adjusted gross income (AGI), reducing eligibility for need-based aid by as much as half of the distribution amount. Dependent students have an income protection allowance that shelters more than $6,000 in total income each year.
Thus, if a 529 plan is owned by a grandparent, aunt, uncle, non-custodial parent or a complete stranger, distributions will have a harsh impact on eligibility for need-based aid. There are, however, a few workarounds:
- Change the account owner of the 529 plan to be the student or the parent. Some states do not allow a change in the account owner or limit the circumstances under which the account owner can be changed.
- Rollover one year’s qualified expenses to a parent-owned 529 plan after filing the FAFSA. A 529 plan can be rolled over to another 529 plan for the same beneficiary once per 12-month period. 529 plans are reported based on the asset value as of the date the FAFSA is filed. So, by waiting to rollover until after the FAFSA is filed, the money is not reported as an asset. Since the distribution to pay for college costs comes from a parent-owned 529 plan, there is no untaxed income to the student to be reported on a subsequent year’s FAFSA. The parent-owned 529 plan should be set up in the same state to avoid state recapture rules.
- Wait until after January 1 of the sophomore year in college to take a distribution. Because the FAFSA uses the prior-prior year for reporting income, there will be no subsequent year’s FAFSA to be affected, assuming the student is not going on to graduate school.
- Take a non-qualified distribution after the student graduates. A non-qualified distribution could be used to pay down student loan debt.
Grandparents sometimes set up a grandparent-owned 529 plan because of concerns about a spendthrift parent. They don’t trust the parent to use the 529 plan money to pay for college. An alternative is to use a custodial 529 plan account, where the student is the account owner and the grandparent is the custodian. Since there is no annual tax reporting with a 529 plan, the grandparents don’t need to tell the student and parents that there is a 529 plan. Instead, they can surprise them with the good news when college approaches.
Grandparents sometimes set up a grandparent-owned 529 plan because of a misunderstanding concerning contributions. Anyone can make a contribution to any 529 plan. You don’t have to be the account owner to make a contribution to a 529 plan. (However, a few states limit state income tax deductions for contributions to the state’s 529 plan, allowing a deduction only if the taxpayer is the account owner.)
The CSS/Financial Aid PROFILE form has less favorable treatment of 529 plans. If the student is a beneficiary on a 529 plan, it must be reported on the PROFILE, even if it is owned by someone other than the student or parent. Also, all 529 plans that are owned by siblings must be reported on the PROFILE, if the sibling is under age 19 and not enrolled in college.
529 plans do not have an annual contribution limit. But, contributions above the annual gift tax exclusion might be subject to gift taxes, currently $14,000 ($28,000 for a couple making a joint contribution). However, 529 plans provide an option of five-year gift tax averaging when the annual contributions exceed the gift tax exclusion. This treats the contribution as though it were made ratably over a five-year period. It allows a lump sum contribution of up to five times the annual gift tax exclusion, up to $70,000 ($140,000 for a couple).
529 plans do have cumulative contribution limits, which vary by state. Typically, the contribution limit is based on five to seven years of college costs at the highest-cost college in the state, updated periodically. In most states, the cumulative contribution limit is several hundred thousand dollars.
Contributions must be made in cash. You cannot transfer stocks into a 529 plan.
Contributions can be made by anyone.
The beneficiary must have a Social Security Number. If a parent wants to create a 529 plan before a child is born, they can set it up in their name and change the beneficiary to the child after the child is born.
The beneficiary can be changed to a member of the family of the current beneficiary. Members of the beneficiary’s family include:
- The beneficiary’s spouse
- The beneficiary’s son, daughter, stepson, stepdaughter, foster child, adopted child or their descendants
- The beneficiary’s brother, sister, stepbrother or stepsister
- The beneficiary’s father, mother or any ancestor
- The beneficiary’s stepfather or stepmother
- The beneficiary’s niece, nephew, aunt or uncle
- The beneficiary’s first cousin
- The beneficiary’s son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law or sister-in-law
- The spouse of a member of the family of the beneficiary
There are no age limits on the beneficiary.
Investment options vary by 529 plan, but generally involve a limited set of mutual funds. Usually there is an all stock fund or a S&P 500 fund and a bond fund, which are mixed to create age-based asset allocation funds.
Investors can change the asset allocation (the mix of investments) twice a year.
Most states offer at least one direct-sold 529 plan and at least one advisor-sold 529 plan. Direct-sold 529 plans are obtained directly from the state. Advisor-sold 529 plans are provided through investment advisors. The advisor-sold 529 plans provide more control over the investments, potentially yielding a greater return on investment but also charge higher fees. The net return on investment after subtracting fees usually is higher for the direct-sold 529 plans. Minimizing expenses is the key to maximizing net returns.
Investors cannot pledge a 529 plan as security for a loan.
Coordination Restrictions and Other Limitations
Taxpayers cannot use the same qualified higher education expenses to qualify for both a tax-free distribution from a 529 plan and the American Opportunity Tax Credit (AOTC). Accordingly, taxpayers should reserve up to $4,000 in tuition and textbook expenses each year to be paid with cash or loans to qualify for the maximum AOTC. The AOTC is worth more per dollar of qualified expenses than a tax-free distribution from a 529 plan.
You also can’t double-dip by using the same expenses to justify distributions from a 529 plan, prepaid tuition plan and Coverdell education savings account. You can make contributions to all three types of college savings plan in the same year.
There is no income phase-out on 529 plan distributions.
For more informationa bout 529 plans, see Chapter 8 of IRS Publication 970, Qualified Tuition Program (QTP).
Distributions from 529 college savings plans are reported on IRS Form 1099-Q, Payments from Qualified Education Programs.