529 Plans: Flexibility for education expenses

529 plans, officially known as qualified tuition programs under federal law, were first created by the U.S. Congress in 1996 as part of the Small Business Job Protection Act. Named after Section 529 of the Internal Revenue Code that governs the plans, 529 plans are state-sponsored investment accounts taxpayers can use to save for education expenses. For your clients, these plans offer significant tax benefits, flexibility, and a range of tax planning and advisory opportunities.

There are two primary types of 529 plans: college savings plans and prepaid tuition plans. While they share the same federal tax advantages, there are important differences between them.

• College savings plans: These individual investment accounts are run by the states. The account’s value will fluctuate based on the performance of the underlying investments. When it’s time for college, the beneficiary of the  account can use the funds at any college in this country and abroad as long as the school is accredited by the U.S. Department of Education.The funds can be used to pay for a wide range of qualified education expenses, including tuition, room and board, books, supplies, and computer software required to complete coursework.
• Prepaid tuition plans: These plans allow investors to lock in the cost of tuition by purchasing credits at participating colleges and universities at today’s prices. While this can provide a hedge against rising tuition costs, prepaid tuition plans are more restrictive. For example, they often cover only tuition and mandatory fees, and usage is limited to specific institutions or within a particular state. Prepaid tuition plans may be sponsored by states on behalf of public colleges or by private colleges, and are typically offered only to residents of the state in which the college is located.

Benefits of 529 plans

There are many benefits of 529 plans, including the following:

• Tax-free growth. Earnings in a 529 plan grow federal tax-free and are not taxed when withdrawn, provided they are used for qualified education expenses. 
• State tax benefits. Many states offer tax deductions or credits for contributions to a 529 plan. Benefits vary widely from state to state, with some offering substantial deductions, while others offer no state tax incentives at all. Some states exempt qualified withdrawals from income tax or offer an annual tax deduction for contributions. A few states provide matching scholarships or matching contributions. Some states require contributions to be made to that state’s 529 plan to qualify for the tax benefit, while others allow deductions or credits for contributions to any 529 plan.
• Favorable federal estate tax treatment. Plan contributions aren’t considered part of the investor’s estate for federal tax purposes, even though investors retain control of the account.
• Availability. Section 529 plans are available to anyone, regardless of income level. The investor does not need to be a parent to set up an account. 
• High contribution limits. The total amount investors can contribute to a 529 plan is generally high. Most plans have limits of $300,000 or more. Under federal law, contributions to a 529 plan cannot exceed the expected cost of the beneficiary’s qualified education expenses.
• Professional money management. 529 plans offer professional money management to investors who are too busy, inexperienced, or reluctant to choose their own investments.
• College savings plan variety. Investors aren’t limited to the college savings plan available in their home state. They can shop around for the plan with the best money manager, performance record, investment options, fees, state tax benefits, and customer service.
• Rollovers.  Rollovers are allowed by federal law and are not subject to plan rules. Investors can do a “same beneficiary” rollover—a rollover without a change of beneficiary—to another 529 plan once every 12 months without penalty.
• Simplicity.  It’s relatively easy to open a 529 account. The investor fills out an application, chooses a beneficiary, and contributes funds. Most plans offer automatic payroll deduction or electronic funds transfer from the investor’s bank account.

Drawbacks of 529 plans

Just as there are many benefits, there are also several drawbacks.

• Investment options. 529 plans offer little control over an investor’s specific investments. With a college savings plan, investors may be able to choose among a variety of investment portfolios when they open the account, but they can’t direct the portfolio’s underlying investments. With a prepaid tuition plan, investors can’t choose anything; instead, the plan’s money manager is responsible for investing their contributions.
• Investment guarantees. College savings plans don’t guarantee investment return. Investors can lose some or all of the money they have contributed. Even though prepaid tuition plans typically guarantee investments to increase in value at the same rate as college tuition, some plans sometimes announce modifications to the benefits they’ll pay out due to projected actuarial deficits.
• Investment flexibility. If investors are unhappy with their portfolio’s investment performance in their 529 plan, they can direct future contributions to a new portfolio, assuming your client’s plan allows it, but it may be more difficult to redirect your existing contributions. Some plans may allow you to make changes to your existing investment portfolio twice per calendar year or upon a change in the beneficiary. In either case, it depends on the rules of the plan.
• Nonqualified withdrawals. If funds are withdrawn from a 529 plan and not used to pay for qualified education expenses, the investor will  generally be subject to income tax and an additional 10% federal tax penalty on earnings. State tax and  penalties may also apply. With a prepaid tuition plan, the investor must either cancel their contract to receive a refund or take whatever predetermined amount the plan will give them for a nonqualified withdrawal. Some plans may make the investor forfeit all of their earnings; others may pay a nominal amount of interest.
• Resident state considerations. Investors should consider whether their home state offers state tax or other benefits only available for investments in their home state’s 529 plans. 529 plans offered outside their resident state may not provide the same tax benefits as those offered within their state. Such benefits include financial aid, scholarship funds, and protection from creditors.
• Fees and expenses. Typically, there are fees and expenses associated with 529 plans. College savings plans may charge an annual maintenance fee, administrative fees, and an investment fee based on a percentage of your account’s total value. Prepaid tuition plans may charge an enrollment fee and various administrative fees.

Recent legislative changes

The usage of 529 plans has expanded in recent years with the passage of the Tax Cuts and Jobs Act (TCJA) of 2017, SECURE Act of 2019, and the SECURE Act 2.0 of 2022.

• Use for K-12 tuition. A significant change brought about by the TCJA was the ability to use up to $10,000 per year from a 529 plan to pay for elementary, middle, and high school tuition at private, public, or religious schools. 
• Rollover to ABLE account.The TCJA allows rollovers in limited amounts from a 529 account to the ABLE account of the designated beneficiary or their family member.
• Student loan repayment. The SECURE Act expanded the permissible uses of 529 funds to include student loan repayments, allowing up to $10,000 to be used to pay off student loans for the plan beneficiary or their siblings.
• Apprenticeship programs. The SECURE Act allows 529 plan funds to be used for expenses associated with registered apprenticeship programs, including costs for fees, supplies, and equipment. 
• Rollover to ROTH IRA. As of January 2024 under the Secure Act 2.0,  unused funds from a 529 plan can be rolled over, tax and penalty free, into a Roth IRA account in the beneficiary’s name up to a $35,000 lifetime limit. Conditions that must be met include:
  • This limit is subject to the annual Roth IRA contribution limit, which is $7,000 in 2024.
  • The 529 account must have been open for more than 15 years.
  • Funds cannot be rolled into a Roth IRA until 5 years after the funds were contributed or earned.
• Grandparent rule. Allows grandparents to invest in a 529 plan to fund a grandchild’s education without affecting the student’s financial aid eligibility. Previously, withdrawals could have reduced financial aid awards by up to 50% of the amount of the distribution. 

Tax planning with your clients

Understanding the strategic opportunities offered by 529 plans can significantly enhance the value tax professionals provide to their clients. Here are several key areas to consider:

Early contributions and compounded growth

One of the most effective strategies is to encourage clients to start contributing to a 529 plan as early as possible. The power of compounding means that even small contributions made early on can grow substantially over time, reducing the financial burden when it comes time to pay for education expenses.

Maximizing state tax benefits

It’s essential to understand the specific rules and limits in states that offer tax deductions or credits for 529 contributions. Advising clients to maximize these contributions up to the deductible limit can provide immediate state tax savings.

Gifts and superfunding 

Contributions to a 529 plan qualify for the annual gift tax exclusion, which is $18,000 per beneficiary for 2024 ($36,000 for married couples). 529 plans offer a unique feature that allows for “superfunding,” where a donor can contribute up to five times the annual gift tax exclusion amount ($90,000 for individuals or $180,000 for married couples) in a single year, and applied against the annual gift tax exclusion equally over a five-year period. It’s crucial to carefully document these contributions and ensure that no additional gifts are made to the same beneficiary within the five-year period to avoid gift tax complications. Death of the investor prior to the end of the five-year period may result in a portion of the contribution to be included in the investor’s estate.

Tuition gift exclusion

Payments made directly to the educational institution for tuition are excluded from gift tax even if the amount exceeds the annual exclusion amount.

Account flexibility and beneficiary changes

The beneficiary of a 529 plan can be changed without tax consequences, provided the new beneficiary is a member of the original beneficiary’s family. This flexibility allows families to adjust their plans as circumstances change, such as reallocating funds to a sibling if the original beneficiary receives a scholarship or decides not to pursue higher education. 

529 plans and tax planning

529 plans offer significant opportunities for tax savings, wealth transfer, and education funding. As a tax professional, your expertise in navigating the complexities of these versatile savings vehicles can provide immense value to your clients. By understanding the tax benefits, staying informed about legislative changes, and leveraging strategic planning opportunities, you can help clients maximize the potential of 529 plans, ensuring that they are well-prepared for the future educational needs of their families.