529 college savings plans (529 plans) are one of three types of qualified education benefits, the other types being prepaid tuition plans and Coverdell education savings accounts. Distributions from a 529 college savings plan are tax-free if used to pay for qualified education expenses subject to certain additional restrictions.
Contributions to a 529 plan are made with after-tax dollars. Earnings within a 529 college savings plan occur on a tax-deferred basis.
Distributions are tax-free if used to pay for qualified higher education expenses. Qualified higher education expenses include tuition, fees, books, supplies, equipment, and expenses for special-needs services required for enrollment or attendance. If enrolled on at least a half-time basis, room and board is also a qualified higher education expense; however, this amount cannot exceed the room and board allowances specified by the educational institution or, if greater, the actual amount charged by the educational institution for institutionally owned or operated housing. (Paying off student loans is not considered a qualified higher education expense under current law, even if those loans were used to pay for qualified higher education expenses.)
The earnings portion of a non-qualified distribution is taxed at the beneficiary’s rate. Non-qualified distributions may be subject to a 10 percent tax penalty, except when the beneficiary dies or becomes disabled, or receives tax-free scholarship, veterans’ education assistance or employer-provided tuition assistance, among other exceptions.
529 College Savings Plans are state-sponsored programs for saving for future college expenses. Like a Roth IRA, the taxpayer invests after-tax dollars. The earnings accumulate on a tax-deferred basis and may be entirely tax-free if used for qualified higher education expenses.
Contributions may come from any individual, including the beneficiary, the beneficiary’s parents, grandparents, aunts, uncles or other relatives, and people unrelated to the beneficiary. Contributions may also come from corporations, trusts and other organizations. Some 501(c)(3) tax exempt charitable organizations award scholarships through a contribution to the student’s 529 college savings plan.
There is no annual limit to the contributions to a 529 college savings plan. Cumulative limits vary by state and are generally based on the projected cost of five to seven years of postsecondary education at the highest cost public or private college or university in the state. The maximum contribution limits are typically about $350,000 and may range from as low as $235,000 to as high as $452,210. Maximum contribution limits can change annually.
However, contributions to a 529 college savings plan may be subject to gift taxes. Generally, people can contribute up to the annual gift tax exclusion ($14,000 in 2013, 2014 and 2015) to each beneficiary’s 529 plan, twice that for a married couple, without incurring gift taxes. For example, a grandmother and grandfather could together give up to $28,000 to each of their grandchildren. If the contribution exceeds the annual gift tax exclusion, then five-year gift tax averaging would apply. This treats the contribution as having been made proportionately over a five-year period beginning with the current tax year. If the contributor dies during the five-year period, only part of the gift will be treated as completed and hence removed from the contributor’s estate. The portion of the gift corresponding to periods after the death of the contributor will remain in the contributor’s estate. For example, if an aunt gives $30,000 to her nephew’s 529 College Savings Plan, it will be treated as though she gave $6,000 per year for five years. If she dies during the second year, $12,000 will be excluded from her estate and $18,000 will be included.
There is no age limit on contributions or distributions. Funds can be used for undergraduate, graduate or professional school education at any college or university that is eligible for Title IV federal student aid.
Contributions must be made in cash or cash equivalents. For example, checks, money orders, credit card payments, electronic funds transfer (EFT) and rollover from another 529 plan are permissible. A 529 plan may not be pledged as security for a loan.
Investments are chosen from a basket of mutual funds that typically include all-stock funds, low-risk funds and age-based asset allocations. In 2014 and prior years, investors may not otherwise direct the specific investments of the 529 plan account. However, the Tax Increase Prevention Act of 2014 made changes to permit investors to directly and indirectly specify investments up to two times per calendar year, effective starting January 1, 2015. The state 529 college savings plans will need to make changes to permit account owners to select individual stocks and bonds, but it is likely that many will make the necessary changes.
Contributions to a 529 college savings plan are not eligible for the gift tax exclusion as direct tuition payments to an educational institution under 26 USC 2503(e).
The beneficiary of a 529 college savings plan may be changed to a member of the family of the current beneficiary. The 529 college savings plan may be rolled over to another 529 college savings plan or prepaid tuition plan for the same beneficiary or a member of the family of the current beneficiary, but rollovers for the same beneficiary are permitted only once per 12-month period.
Members of the family of the beneficiary include the beneficiary’s spouse, the beneficiary’s son, daughter, stepchild, foster child, adopted child or their descendants, the beneficiary’s brother, sister, stepbrother or stepsister, the beneficiary's father, mother or any ancestor of the beneficiary's father or mother, the beneficiary's stepfather or stepmother, the beneficiary's nephews, nieces, aunts and uncles, 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 any of these family members, and first cousins.
529 college savings plans cannot be established for an unborn child. However, a child’s parent can establish a 529 plan in his or her own name and change the beneficiary after the child is born and has a Social Security number.
Families can invest in any state's 529 college savings plan, but should consider their own state’s plan first. Many state 529 plans offer special benefits for state residents.
Many states offer a state income tax deduction or tax credit for all or part of the taxpayer’s contributions to the state’s 529 plan, a benefit that is not available to investments in a Roth IRA.
These thirty-two states provide a state income tax deduction: Alabama, Arizona, Arkansas, Colorado, Connecticut, Georgia, Idaho, Illinois, Iowa, Kansas, Louisiana, Maine, Maryland, 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.
Of the states listed above, four states (Colorado, New Mexico, South Carolina and West Virginia) allow a deduction for the full amount of the contribution to the state’s 529 plan and a dozen additional states (Alabama, Arkansas, Connecticut, Illinois, Michigan, Mississippi, Missouri, Nebraska, New York, North Dakota, Oklahoma, Pennsylvania) have contribution limits that are likely to exceed most parent’s annual contributions.
Three states, including Indiana, Utah and Vermont, provide a state income tax credit.
Six states (Arizona, Kansas, Maine, Missouri, Montana and Pennsylvania) provide for tax parity, where they provide a tax deduction for contributions to any state’s 529 plan.
Eleven states require the taxpayer to be the account owner to claim the state income tax deduction or tax credit for contributions to the state's 529 college savings plan: District of Columbia, Iowa, Maryland, Missouri, Montana, Nebraska, New York, Rhode Island, Utah, Vermont and Virginia.
Distributions from 529 college savings plans include both earnings and a return of contributions. Each is deemed to be included proportionately within any distribution. For example, if one third of the balance of a 529 plan is from earnings and two thirds from contributions, then one third of any distribution will be assumed to have come from earnings.
The tax treatment of a non-qualified distribution differs according to whether one is considering the part of the distribution that comes from earnings or the part that came from contributions.
If a 529 college savings plan has lost money, it may be possible to claim a loss on the beneficiary's federal income tax return. The refund value of the 529 plan must be less than the unrecovered basis (contributions minus the portion of distributions corresponding to contributions). Losses are listed as miscellaneous itemized deductions on Schedule A of IRS Form 1040. To claim a loss, the taxpayer must liquidate the 529 plan and the loss must exceed 2 percent of AGI. Losses may also be used to offset gains distributed from other 529 plans.
If a 529 college savings plan is owned by a dependent student (custodial account) or a dependent student’s parent, it is reported as though it were a parent asset on the Free Application for Federal Student Aid (FAFSA). This includes 529 plans that are owned by a stepparent, so long as the stepparent is married to the custodial parent. Distributions from such a 529 plan are not reported as income on the FAFSA.
If a 529 college savings plan is owned by anyone other than the student or the parent, it is not reported as an asset on the FAFSA. This includes 529 plans owned by a grandparent, an aunt or an uncle. (If the student's parents are divorced, 529 plans owned by the custodial parent or the custodial parent's spouse are reported as assets on the FAFSA, but 529 plans owned by the non-custodial parent are not reported as assets on the FAFSA.) If a 529 plan is not reported as an asset on the FAFSA, distributions from such a 529 plan are reported as untaxed income to the beneficiary (the student) on the subsequent year's FAFSA.
Typically $30,000 to $50,000 of parent assets are sheltered on the FAFSA, based on the age of the older of the parents listed on the FAFSA. (If the student's parents are divorced, only the custodial parent is listed as a parent on the FAFSA. If the custodial parent has remarried, the stepparent is also listed as a parent on the FAFSA. The non-custodial parent is not listed as a parent on the FAFSA.) In addition, if parent income is below $50,000 a year and the parents are eligible to file an IRS Form 1040A or 1040EZ, or the family qualifies for certain means-tested federal benefit programs, the family will qualify for the simplified needs test, which disregards all assets. In a worst case scenario the parent assets will be assessed on a bracketed scale based on the amount of assets, with a top bracket of 5.64 percent.
Untaxed income to the student will reduce eligibility for need-based financial aid by as much as half of the amount of the distribution. This has a much harsher impact on eligibility for need-based aid than a student or parent-owned 529 plan.
There are, however, a few workarounds if the 529 college savings plan is owned by someone other than the student or the parent.
Sometimes a student’s grandparents or other relatives set up a 529 plan with themselves as the account owner because of concerns that the parents might spend the money on something other than college costs. A better approach is to establish a custodial 529 plan, where the student is both account owner and beneficiary. Since the student is a minor, the grandparents can serve as custodians until the student reaches the age of majority. This gives the grandparents control over the account, so they can prevent non-qualified distributions. Since earnings accumulate on a tax-deferred basis, they can even avoid telling the family about the existence of the 529 plan. Though it is usually better if the student knows about the college savings plan, since the expectation that the student will go to college increases the likelihood that the student will enroll in college.
The CSS/Financial Aid PROFILE form considers all 529 college savings plans and prepaid tuition plans that name the student as a beneficiary. The PROFILE form also considers 529 plans and prepaid tuition plans that are owned by siblings who are under age 19 and not yet enrolled in college.
Taxpayers cannot double dip. For example, taxpayers cannot use the same expenses to justify both the exclusion from income for distributions from a 529 college savings plan and another education tax benefit, such as the tax-free portion of a qualified scholarship, tax-free distributions from Coverdell education savings accounts or the American Opportunity Tax Credit.
Contributions may be made to a 529 college savings plan, prepaid tuition plan and Coverdell education savings account for the same beneficiary in the same year.
The exclusion from income for distributions from 529 college savings plans is not subject to a phaseout on the tax-free treatment of the distributions.
The legislation authorizing the exclusion from income for distributions from 529 college savings plans does not expire.
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