Article Highlights:
- What is a Sec 529 Plan?
- Tax Benefits of Sec 529 Plans
- Funding a Sec 529 Plan
- Who Can Contribute to a Sec 529 Plan
- Gift Limitation and the 5-Year Option
- Form 709 and Making Up Contributions
- Higher Education Credits
- Impact on Financial Aid
- Qualified Expenses and Recent Flexibility Enhancements
- Refunds & Recontribution of Funds
- Handling Remaining Funds Post-Education
- 529 Plan Rollovers to Roth IRAs
- 529 Plan Rollovers to ABLE Accounts
- Contribution Limits and the Importance of Early Planning
Funding a child’s education can be a daunting task for many parents and guardians. With the rising costs of post-secondary education, finding a tax-efficient way to save and grow education funds is crucial. Enter the Section 529 Plan, a powerful tool in the arsenal of education savings options. This blog post will delve into the intricacies of the Sec 529 Plan, exploring its tax benefits, funding mechanisms, gift limitations, and much more.
What is a Sec 529 Plan? –
A Sec 529 Plan, named after Section 529 of the Internal Revenue Code, is a tax-advantaged savings plan designed to encourage saving for future education costs. These plans, legally known as “qualified tuition plans,” are sponsored by states, state agencies, or educational institutions. They come in two varieties: prepaid tuition plans and education savings plans. The focus here will be primarily on the latter, given its broader applicability and flexibility.
Tax Benefits of Sec 529 Plans –
The primary allure of Sec 529 Plans lies in their significant tax benefits. Contributions to a 529 Plan grow tax-free, and withdrawals for qualified education expenses are not subject to federal income tax. This feature allows for the potential accumulation of a substantial education fund, as earnings are not eroded by taxes over time. While there is no federal tax deduction for contributions to 529 Plans, some states offer tax deductions or credits for contributions, further enhancing the tax efficiency of these plans.
Funding a Sec 529 Plan –
Contributions to a 529 Plan must be made in cash and are made with after-tax dollars. Most plans have very accessible minimum contribution requirements, and many offer convenient funding options such as payroll deductions or automatic bank transfers. This flexibility makes it easier for families to start and continue contributing over time.
Who Can Contribute to a Sec 529 Plan –
Anyone can contribute to a Sec 529 Plan. There are no limits on the number of contributors, and there are no income or age limitations. This means that parents, grandparents, other relatives, friends, and even the next-door neighbors can contribute to the student’s Sec 529 Plan. This inclusivity allows for a broad range of potential contributors to help save for a beneficiary’s post-secondary education expenses.
Gift Limitation and the 5-Year Option –
One of the unique aspects of 529 Plans is the generous gift tax treatment. In 2024, an individual can contribute up to $18,000 per beneficiary without triggering the gift tax, thanks to the annual gift tax exclusion. For those looking to accelerate their contributions, the tax code permits a lump-sum contribution of up to five times the annual exclusion amount (e.g., $90,000 in 2024) to be treated as if it were spread over a five-year period. This option allows for significant upfront contributions without gift tax implications, although it requires the filing of Form 709 to report the election.
Form 709 and Making Up Contributions –
When opting for the 5-year accelerated contribution, the contributor must file Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return, in the year of the contribution. This form documents the election to spread the gift over five years for tax purposes. If the annual gift tax exclusion increases within those five years, contributors can make additional “makeup” contributions, aligning their gifts with the new exclusion limits.
Higher Education Credits –
Taxpayers can claim an American Opportunity credit or Lifetime Learning credit for a taxable year and exclude from gross income amounts distributed (both the principal and the earnings portion) from a Sec. 529 Plan on behalf of the same student provided the distribution is not used for the same expenses for which a credit was claimed.
Impact on Financial Aid –
Predicting financial aid eligibility is no easy task since it is based on a myriad of factors, including income, the age of the parents, and the methodology used. A question that always arises when discussing the benefits of saving for college is the impact those savings will have on future financial aid. Investing in a college savings plan can affect financial aid eligibility to some degree, but 529 Plans are typically viewed as a parental asset, rather than a child’s and that means that a financial aid officer would count only a small portion of the assets toward the financial aid eligibility. If the account owner is not the parent or dependent student (perhaps a grandparent), eligibility for financial aid is not affected, but distributions from grandparent-owned plans will likely be attributed to the student.
Qualified Expenses and Recent Flexibility Enhancements –
Funds from a Sec 529 Plan can be used for a wide range of education-related expenses, including tuition, fees, books, supplies, and equipment required for enrollment or attendance at an eligible educational institution. Originally intended only to be used for post-secondary education expenses, Congress relaxed that limitation, so the funds in 529 Plans now can be withdrawn to pay for grades K-12 tuition expenses, up to a limited amount per year, and for expenses related to apprenticeship programs. Additionally, up to $10,000 can be used to repay the beneficiary’s student loans, extending the utility of the plan beyond traditional college expenses.
Refunds & Recontribution of Funds –
When Sec 529 qualified tuition program funds are distributed for a beneficiary’s qualified higher education expenses, but some portion of those expenses subsequently is refunded to the beneficiary those funds can be recontributed to the Sec 529 Plan within 60 days of the date of the refund and avoid taxation. For example, when the beneficiary drops a class mid-semester, the portion of a distribution refunded to a Sec 529 beneficiary is not subject to income tax to the extent that, within 60 days of the date of the refund, it is recontributed to a Sec 529 Plan of which the individual is a beneficiary.
Handling Remaining Funds Post-Education –
If there are funds remaining in a 529 Plan after the beneficiary’s education is complete, several options are available. The account can be left to grow for future education expenses, including graduate school. Alternatively, the beneficiary can be changed to another family member who can use the funds for their education expenses. While non-qualified withdrawals are subject to income tax and a 10% penalty on earnings, the flexibility in beneficiary designation mitigates the risk of funds being “trapped” in the account.
529 Plan Rollovers to Roth IRAs –
Beginning in 2024, a significant new provision came into effect, offering a new financial planning opportunity for individuals with funds in a Sec 529 Plan. This provision allows for the rollover of funds from a 529 Plan into a Roth IRA under specific conditions, without incurring taxes or penalties. This development addresses a common concern among families and students regarding the potential for unused 529 Plan funds to be trapped, unless withdrawn with a penalty for non-qualified expenses. The flexibility introduced by this provision is anticipated to encourage more contributions to 529 Plans, as it provides an alternative use for the funds that can benefit the account beneficiary in the long term.
To take advantage of this rollover opportunity, several conditions must be met:
- Lifetime Rollover Limit – The total amount that can be rolled over from 529 Plans to Roth IRAs is capped at $35,000 over the beneficiary’s lifetime. This limit is designed to prevent abuse of the provision while still offering a significant opportunity for long-term savings.
- Account Aging Requirement – The 529 account from which funds are being rolled over must have been open for more than 15 years. This requirement ensures that the provision is used primarily for its intended purpose of repurposing long-term education savings rather than as a short-term tax avoidance strategy.
- Contribution Limits – Rollovers are subject to the Roth IRA’s annual contribution limits, which means that the amount rolled over each year cannot exceed the maximum contribution limit for Roth IRAs in that year. This condition aligns the rollover with existing Roth IRA contribution rules, maintaining fairness and consistency in retirement savings contributions.
- Five-Year Rule – The aggregate amount contributed to the 529 account in the previous five years cannot be rolled over. This rule is likely in place to prevent recent contributions, which may not have been intended for education expenses, from being quickly redirected into a Roth IRA.
Implications – This new rollover option is a significant addition to the financial planning toolkit, offering a pathway for education savings to be repurposed into retirement savings if they are not needed for their original purpose.
529 Plan Rollovers to ABLE Accounts –
A provision, under certain circumstances, permits rolling over funds from a Sec 529 Plan to an ABLE account. ABLE accounts provide the means for individuals and families to contribute and save for the purpose of supporting individuals, blind or severely disabled before turning age 26 (46 beginning for years after 2025), in maintaining their health, independence, and quality of life.
Here’s a summary of the key provisions:
- Tax- and Penalty-Free Rollovers – A distribution from a 529 Plan can be rolled over into an ABLE account without incurring taxes or penalties. This provision allows for the funds initially intended for education expenses to be repurposed for the broader range of expenses covered by ABLE accounts, which are designed to support individuals with disabilities.
- Time Limit – The rollover must be completed within 60 days of the distribution from the 529 Plan to qualify for the tax- and penalty-free treatment.
- Beneficiary Requirements – The rollover must be for the benefit of the same designated beneficiary of the 529 Plan or a member of the beneficiary’s family. This ensures that the funds remain within the family and are used to support a relative with disabilities.
- Annual Contribution Limits – The total amount rolled over, when combined with any other contributions to the ABLE account for the year, cannot exceed the ABLE account’s annual contribution limit. For example, if the annual limit is $16,000 and $9,000 is rolled over from a 529 Plan, only an additional $7,000 can be contributed to the ABLE account in that year.
- Expiration Date – This rollover provision is available through 2025, indicating that the law has set a sunset date for this option, after which it may need to be renewed or could expire unless legislative action is taken.
- Family Member Definition – For these rollovers, family members include spouses, children, siblings, parents, stepparents, nieces, nephews, aunts, uncles, in-laws, and first cousins of the designated beneficiary. This broad definition allows for flexibility in choosing the new ABLE account beneficiary within the family.
An example of how this provision can be used is if an individual, who no longer has education expenses and has remaining funds in a 529 Plan, chooses to roll over the balance to an ABLE account for a qualifying family member. This action can help support the family member’s disability-related expenses without incurring taxes or penalties on the rollover amount, subject to the annual contribution limits of the ABLE account.
Contribution Limits and the Importance of Early Planning –
While there is no annual federal limit on 529 Plan contributions, each state’s 529 Plan has a maximum total contribution limit, often reflecting the estimated cost of a high-end college education. Starting a 529 Plan early in a child’s life maximizes the time for contributions to grow, leveraging the power of compounding interest and tax-free earnings.
The Sec 529 Plan stands out as a robust, flexible, and tax-efficient vehicle for saving for education expenses. Its benefits, including tax-free growth, high contribution limits, and the ability to change beneficiaries, make it an attractive option for families planning for the future. By understanding the nuances of how these plans work, including the strategic use of the 5-year contribution option and the recent enhancements to plan flexibility, families can better position themselves to support their loved ones’ educational aspirations. Starting early and contributing regularly can make the dream of a debt-free education a tangible reality.
If you have questions about how Sec 529 Plans might fit into your family’s long range planning, please give this office a call.
If you have any questions, please contact our office at (503) 224-5321. Isler Northwest LLC is a firm of business advisors and CPAs in Portland, Oregon. Our service goal at Isler Northwest is to earn our clients’ trust as their primary business and financial advisor.
Isler Northwest
(503) 224-5321
1300 SW 5th Avenue
Suite 2900
Portland, Oregon 97201
