The unique benefits of 529 college savings plans.

• Author: Toolson, Richard

Sec. 529 plans have many tax-planning advantages. This article discusses them, provides examples, and addresses recent tax developments that have expanded the definition of tax-free qualified educational distributions from these plans. It also compares a 529 plan to a Roth IRA as a funding source for higher education.

To start with the basics, a 529 plan is legally known as a "qualified tuition plan." It is a tax-advantaged plan that has as its primary purpose to encourage savings for the cost of a college education. All states (other than Wyoming), as well as the District of Columbia, offer at least one type of 529 plan. Account owners of 529 plans do not have to be a resident of a state to establish a 529 plan in that state; they are free to choose which state best meets their particular situation. Once a 529 plan is opened, the source of contributions is not limited to the owner; anyone can contribute to it.

Distributions from a plan are tax-free to the distributee if they are for qualified higher education expenses. The plan owner names a beneficiary at the time the plan is set up. Each 529 account has one owner and one beneficiary. The owner and the beneficiary are generally allowed to be the same person. Normally, the owner is allowed to name a successor who will become the owner upon the death of the original owner. A few states may prohibit the owner and beneficiary from being the same person or disallow a successor owner to be named.

The owner is allowed to change beneficiaries without income tax consequences as long as the new beneficiary is a member of the family of the old beneficiary. (1) The IRS provides a broad definition of who is a related family member of the current beneficiary. For example, along with siblings, this would include first cousins and nephews and nieces. (2)

Contributions to a 529 plan

Contributions to a 529 plan are made with after-tax dollars. Consequently, there are no income tax ramifications when contributions are made. All earnings, such as capital gains, dividends, or interest generated within the plan, are allowed to grow tax-free. There is no annual limit on contributions. Contributions to a 529 plan are considered gifts, however, and are subject to the gift tax provisions. These include an annual gift tax exclusion per donee that in 2023 is $17,000 ($34,000 if gift splitting). (3) Moreover, the plan owner can make an election to use five annual exclusions in one year without triggering a taxable gift. If the current annual exclusion of $17,000 remained constant over the five-year period, $85,000 ($170,000 with gift splitting) could be contributed in a single year. (4) The annual gift tax exclusion would no longer be available for the following four years if this election were made.

In addition, each state imposes an aggregate, albeit generous, maximum contribution balance per beneficiary. These limits currently range from $235,000 to $550,000. The aggregate contribution limit is intended to be sufficient to fund an expensive four-year college as well as graduate school in the state where the 529 plan is set up. Once the account reaches the limit, no further contributions are accepted. However, earnings from the investments are allowed to grow beyond these limits. If the account balance falls below the state limit because of, for example, a downturn in the stock market, further contributions are allowed. (5) The maximum limit is per state, so nothing prevents another 529 plan from being set up for the same beneficiary in another state. However, contributions to a qualified tuition plan on behalf of any beneficiary are limited to the amount necessary to provide for the beneficiary's qualified higher education expenses.

Qualified higher education expenses

A beneficiary needs to be enrolled at an eligible post-secondary educational institution for his or her college expenses to be qualified higher education expenses. An eligible institution is one described in Section 481 of the Higher Education Act of 1965 and eligible to participate in a student loan program under Title IV of the act. (6)

Qualified higher education expenses are tuition and fees as well as books, supplies, and equipment required for enrollment. (7) Expenses for room and board are allowed only if the student is enrolled at least half-time. (8) Room and board costs are qualified only to the extent that they are not more than the greater of the amount that the school actually charges for living on campus or the allowance for room and board included in the cost of attendance (for federal financial aid purposes) as determined by the school for the period. (9) Additionally, the cost of computers, computer software, peripheral equipment, or internet access is allowed as long as they are used primarily by the beneficiary during the years he or she is enrolled at an eligible institution. (10)

The law known as the Tax Cuts and Jobs Act (TCJA) (11) expanded the definition of "qualified higher education expenses." Under the TCJA, qualified expenses now include up to $10,000 per year for K-12 tuition for any public, private, or religious school. (12) Not all states recognize the tax-free distribution for K-12 schools, so the earnings portion of the distribution for those states would be taxed at the state level and any state tax breaks would be subject to recapture.

The Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019 (13) further expanded the definition of qualified 529 plan educational expenses in two ways: Up to a maximum lifetime limit of $10,000 per beneficiary may be used to pay off student loans. Any interest, however, associated with the payment cannot be deducted on the tax return. (14) Also, 529 distributions can be used for textbooks, fees, and equipment related to apprenticeship programs. (15)

Determining the adjusted qualified education expenses

The beneficiary of a 529 plan receives a Form 1099-Q, Payments From Qualified Education Programs (Under Sections 529 and 530), by Jan. 31 of the following year. Box 1 of the form indicates the gross distribution amount for the year. Box 2 shows the earnings part of the gross distribution. Box 3 shows the basis portion of the gross distribution reported in box 1. As long as the beneficiary's adjusted qualified education...