Qualified Tuition Plans (529 Plans)

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Qualified Tuition Plans (529 Plans)

Most states have tuition programs allowing families to save for a student’s higher education (private colleges and universities now offer them too). These plans qualify for special tax treatment if the funds are used for qualified expenses at a post-secondary school that meets US Department of Education standards for student aid eligibility. These plans are generally referred to as 529 plans for the tax code section that describes how they are treated for tax purposes. States offering such plans may also give favorable tax treatment for contributions, interest, dividends, and distributions from these plans. State tuition plans fall into two categories: pre-paid tuition plans and college savings plans.

How to buy pre-paid tuition plans

Pre-paid tuition plans allow participants to buy tomorrow’s education at today’s prices. They may be purchased with a single lump sum or a series of payments. The state often guarantees that the pre-payments will cover the future cost of education at the state college. If the student chooses not to attend the state college, the state will make available the amount of money equivalent to the cost of the state education at maturity. For example, imagine that a state university costs $8,000 per year today and you pre-pay two years ($16,000), to be redeemed in 8 years. In 8 years, the cost of two years at the state college goes to $24,000. The beneficiary has two years paid for. Should the student wish to attend a non-state school costing $30,000 for two years, the state typically has to rebate only $24,000 (the cost of the equivalent state college tuition). Pre-paid tuition plans are not as popular today as they were a few years ago due to the phenomenal run-up in the investment markets that occurred in past years.

College savings plans

State college savings plans have become more popular because of investment flexibility, and the potential earnings will help to pay for the costs of education. These plans have some tax advantages, too. While the contributions generally are not tax-deductible on your federal taxes, most states offer a tax deduction, reducing taxable income by the amount of the contribution (up to an annual maximum amount set by each state), and the earnings within the plans are tax-deferred until withdrawn. The funds, including all earnings, may be tax-free if used for qualified educational expenses. The contributions may not exceed the amount set by each state. The contribution limits are often set by the plan administrator each year. These plans offer a triple tax advantage: a) a tax deduction on the contributions, b) earnings that grow tax-free, and c) distributions, when used for qualified education expenses, are tax-free too!

Taxes and penalties

There are no income taxes due on the value of 529 plans until the proceeds are distributed. Then income tax is due only on the increased value of the plan over the contributed amount. The taxes are calculated at the beneficiary’s rate, i.e., based on the student’s income. Many states waive income tax on funds used for qualified educational expenses. If funds are disbursed and not used for qualified education expenses, a 10 percent IRS penalty may be due unless the disbursement meets special requirements. The penalty may be waived if the refund of earnings is made because:

• of the death or disability of the beneficiary.
• the beneficiary received a scholarship for educational expenses.
• the beneficiary receives educational assistance through a qualifying employer program.

Qualified higher educational expenses include tuition, fees, books, reasonable room and board, supplies, and equipment required for the beneficiary at an eligible educational institution. The student must be enrolled at least half time.

Transferring funds to other qualified state tuition programs

Amounts can be transferred to other qualified state tuition programs, and beneficiaries can be changed. Amounts in a qualified state tuition program can be transferred tax-free to the qualified state tuition program of another beneficiary. The transfer must be completed within 60 days of the distribution, and the other beneficiary must be a family member of the beneficiary from whose program the transfer is made. The new beneficiary must be the existing beneficiary’s spouse or one of the family members listed below:

• Child or descendant of child
• Stepson or stepdaughter
• Brother, sister, stepbrother, or stepsister
• Parent or ancestor of parent
• Stepfather or stepmother
• Aunt or uncle
• Niece or nephew
• The spouse of any individual listed above
• First cousin

529s vs Coverdells

Qualified state tuition plans are more popular than the Coverdell account because of the higher contribution limits and the ability to use qualified expenses as the basis for the American opportunity tax credit or lifetime learning credit. Also, 529 plans have no restrictions on the income levels of those who contribute to them. Coverdells, meanwhile, permit a wider variety of investment options.

Contributions can be made to both a 529 plan and a Coverdell account. The contribution limits to Coverdell accounts must still be respected, however.

What about unused 529 plan funds?

You have options for any leftover funds, courtesy of recent legislation.

Account owners may withdraw up to $10,000 tax-free for payments toward qualified education loans. There is a $10,000 lifetime limit, however.

Starting in 2024, you will have another option for any unused funds. You will be able to transfer them to a Roth IRA in the beneficiary’s name. Certain rules will apply.

IRS Publication 970 has more information about 529 plans.