This year, my alma mater, Cornell University, admitted a 12-year-old to the Class of 2020. Most 12-year-olds are starting middle school this year, not college. Upon hearing this news, I wondered, “How have his parents saved for college?” and decided it appropriate to write about 529 College Savings Plans.
How do 529 plans work?
College Savings Plans are referred to as 529 plans because Section 529 of the Internal Revenue Code authorizes College Savings Plans. A 529 plan can be started by anyone for any individual; typically, these plans are started by parents or grandparents. Contributions made to a 529 plan of up to $14,000 per donee per year are free of gift tax. Earnings within the plan are not taxed. Once a beneficiary reaches college, distributions can be made from the plan for qualified education expenses on a tax-free basis. If distributions are made in excess of qualified education expenses or for other reasons, penalties can apply. If a beneficiary finishes school and has a balance remaining in the plan, the proceeds can be transferred to a 529 plan for a family member without adverse tax consequences.
Qualified education expenses include tuition, fees, books, supplies, and equipment required for the enrollment or attendance at an eligible education institution, as well as room and board for students who are enrolled more than at half-time. A special needs beneficiary who requires certain services in connection with enrollment and attendance may also use 529 proceeds to cover those costs. There is a dollar limitation on qualified distributions, calculated as the cost of attendance less certain items covered by financial aid. This establishes a cap on amounts that can be distributed from the 529 plan as tax-free distributions in a given year.
Each state offers a 529 plan, but the plans vary from state to state. Each state plan offers different investment options, states have different maximum account values, and some states offer residents incentives to use its plan. For example:
- New Jersey’s maximum account value totaled across all of one beneficiary’s 529 accounts is $305,000. The state does not offer an income tax benefit to its residents; however, it currently offers residents a scholarship of up to $1,500 if the resident attends a New Jersey college.
- New York’s maximum account value is $375,000 and residents are offered a state income tax deduction up to $10,000 for contributions to the state’s 529 plan.
- Pennsylvania’s maximum account value is $452,210 and allows a state income tax deduction for up to $14,000.
What are the tax implications of funding a 529 plan?
Assuming a plan is funded up to $14,000 per donee per year (and that beneficiary receives no other gifts from the donee) the contribution qualifies for the annual exclusion from the gift tax; therefore, a gift tax return does not have to be filed to report the contribution and no part of the $5,450,000 exemption from gift and estate tax is used.
Up to five (5) years of contributions are permitted per donee in one year allowing $70,000 to be contributed under current law. This super-sized contribution requires the filing of a Form 709, Federal Gift Tax Return, and an election must be made on the form to make this contribution a tax free gift. If the donee were to die prior to the expiration of five (5) years, then the pro-rated portion of the gift will be included for estate tax purposes. For example, $70,000 is contributed in year 1. The Contributor dies at the end of year 3. $42,000 ($14,000 x 3) is completed as a gift and $28,000 ($14,000 x 2) is included in the contributor’s estate for estate tax purposes.
Federal tax law provides any individual over the age of 18 can be a custodian of a 529 plan. Typically, a parent serves as the custodian of a 529 plan. Unlike other types of accounts utilized for minors, like UGMA or UTMA accounts, the balance of a 529 plan is not included in the custodian’s taxable estate for estate tax purposes even if the custodian was the source of contributions.
Ultimately, a 529 plan can be a very effective means to fund higher education in a tax advantageous manner. The plan’s earnings are income-tax free as long as the funds are used to fund qualified education expenses. It is also a tax efficient means for grandparents to transfer funds to assist their grandchildren in affording a college education.