529 Education Savings Accounts are named after the section of the IRS code that outlines the rules of the plan. When it began in 1996, the 529 plan was a new way to save and pay for higher education; the money got to grow tax-free and then could be withdrawn tax-free if it was used to pay for qualified higher education expenses. Later the U.S. Congress allowed tax-free withdrawals to pay for K-12 tuition as well as paying down student loans.
529 Rules
- Your annual contributions to a 529 plan are not tax deductible at a federal level. However, more than 60% of states offer a full or partial income tax deduction for contributions to a 529 plan.
- There are contribution limits to a 529 plan. An individual can contribute up to the annual gift exclusion each year; double for couples.
- If contributions or any additional funds gifted toward a 529 plan exceed the annual gifting limit, the surplus would be subject to the federal gift tax.
- As an option, you can choose to contribute a lump sum equal to five years of annual gift exclusions (double for couples) in a single year and elect to have the contribution considered “spread” over five years. This larger gift would not be subject to the gift tax if the person who made the gift lives for the full five years. This feature can be an effective strategy for long-term estate and gift planning, as the larger upfront gift removes those assets from the donor’s estate and maximizes compound growth inside the 529 plan.
- Annual K-12 tuition withdrawals beyond $10,000, or withdrawals used for non-qualifying expenses, are subject to income tax and a 10% penalty.
K-12 Tuition
529 rules allow for withdrawals of up to $10,000 a year to pay for K-12 tuition at public, private, and religious schools. The provision does not apply to homeschooling. Note that the only qualified expense stated in the rules is “tuition.”
Post-secondary Expenses
Post-secondary expenses include costs required for enrollment and attendance at in-state, out-of-state, public and private colleges, universities, or other eligible post-secondary educational institutions. They include:
- College and graduate tuition and fees
- Vocational and trade school tuition and fees
- Off-campus housing up to the cost of room and board on campus
- Food and meal plans
- Books and supplies
- Computers
- Computer software
- Internet service
- Special needs equipment
- Some business purchases—If the student wants to start a business shortly after college, a significant amount of the business equipment could be purchased with 529 money if purchased during the final years of college and actually used in college courses.
Paying Toward Student Loans
There’s a lifetime limit of $10,000 per beneficiary from 529s to pay down student loans. It applies to federal student loans and most private ones. There is a $20,000 maximum lifetime withdrawal from 529 plans to pay student debt no matter how many children you have. For example, if you have two children, you can withdraw $10,000 to pay toward student debt for each child. If you have three children or more, $20,000 is still the maximum lifetime withdrawal from 529s to go toward student debt. You cannot deduct any student loan interest paid with those withdrawals.
Who Controls the Money
With a 529 plan, the owner controls the money. The account belongs to you. Your child is the beneficiary. You make the decisions about when distributions are made and how much. If there’s money left when your child finishes school, you can reclaim the remaining money, although you will pay income taxes on the earnings portion of the funds, plus an additional 10 percent IRS penalty because the funds were not used for their original purpose. There is an exception if you withdraw funds because of death, disability, or if your child receives a scholarship and doesn’t need the funds for college expenses.
But you don’t have to withdraw unused money. You can change the beneficiary of a 529 to one of your other children, or a grandchild, or even yourself if you intend to go back to school.
Existing 529 plans can be rolled into 529 ABLE accounts. Money can be withdrawn tax-free when the funds are used to pay for qualified disability expenses such as education, job training and support, healthcare, and financial management. To qualify for a 529 ABLE account, a person must have been diagnosed with a significant disability before they turn 26 years old, with a condition expected to last at least 12 consecutive months. The individual must be receiving benefits under Supplemental Security Income (SSI) and/or Social Security Disability Insurance (SSDI), or be able to obtain a disability certification from a doctor. However, if the value of that person’s 529 account exceeds $100,000, they will no longer be eligible for SSI benefits.
Tips for Withdrawing Funds from a 529 Plan Tax-Free
- 529 accounts have more policies and rules than a regular savings account. Do your homework so you know what you can pay for with 529 money and what you can’t.
- Keep receipts. This is a must. Hang on to your proof of expenses for at least 7 years, just in case the IRS has questions. They won’t just take your word for it.
- Ensure that withdrawals match the current year’s payments. If they don’t match you may get hit with taxes when it could have been avoided.
- Don’t wait until the last minute. You need to give your 529 plan administrator sufficient lead time to process the distribution request in the current calendar year.
- 529 distribution rules forbid “double dipping” by using your 529 withdrawals to cover expenses that you’ve used tax incentives to pay for, such as the American Opportunity Tax Credit and the Lifetime Learning Credit.
- If possible, avoid making the distribution payable to the account owner. When 529 plan distributions are payable to the beneficiary, the beneficiary’s college, or K-12 school, a Form 1099-Q will be issued to the beneficiary. Non-qualified distributions payable to a parent may result in a higher tax liability.
- Requesting payment directly to your college can be a simpler way to handle 529 distributions, but always check the school’s policy concerning funds received directly from a 529 plan. The college should treat the 529 plan money as a payment of the school bill.
Disclaimer
This information is presented for informational purposes only and does not constitute an offer to sell, or the solicitation of an offer to buy any investment products. None of the information herein constitutes an investment recommendation, investment advice, or an investment outlook. The opinions and conclusions contained in this report are those of the individual expressing those opinions. This information is non-tailored, non-specific information presented without regard for individual investment preferences or risk parameters. Some investments are not suitable for all investors, all investments entail risk and there can be no assurance that any investment strategy will be successful. This information is based on sources believed to be reliable and Alhambra is not responsible for errors, inaccuracies, or omissions of information. For more information contact Alhambra Investment Partners at 1-888-777-0970 or email us at [email protected].
