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Complete Guide to 529 Plans

Complete Guide to 529 Plans
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529 Plan Overview

529 plans can be a great savings tool for future education expenses. These funds can be for a child, grandchild, or even the account owner themselves. Funds grow tax-deferred and will not be taxed at all if withdrawn for qualified education expenses. 529 plans may also be very useful estate planning tools. In general, there are two broad forms: education savings plans and prepaid tuition plans. The following discussion will focus on 529 education savings plans.

How Do Contributions Work?

Contributions to 529 plans are made with after-tax dollars. These contributions are then invested in a diversified portfolio of funds and grow tax-deferred. Keep in mind that investing in individual stocks is not allowed. Thus, a 529 plan’s investment options are similar to that of a 401(k). 529s technically do not have a set annual contribution limit. A donor – or multiple donors – may contribute however much they want during the year. 

However, a lifetime aggregate limit per beneficiary per state must be adhered to. This aggregate amount depends on the state and can be anywhere from $230,000 to over $550,000. In California, the maximum amount is $529,000 per beneficiary. Once this maximum account balance is reached, no more contributions are permitted. The lifetime aggregate limit applies to all 529s in a single state for a single beneficiary. 

For example, if a child has two California 529 plans, one owned by their parents and the other by their grandparents, the total amount of contributions for the two plans together may not exceed $529,000. However, no penalty will apply if the account balance pushes past this limit due to investment growth and dividends. 

Beneficiaries may also choose to have multiple plans belonging to different states. For example, a beneficiary could max out a 529 in one state and then open another 529 in a separate state and max it out as well. 529 plans also do not have any income limits for the donor like Roth IRAs do. This means that a donor may contribute to a 529 plan even if they have a very high income. A donor may also choose to contribute to a 529 plan that they do not own. 

For example, it is permitted for a grandparent to contribute to a 529 owned by their child for the benefit of their grandchild, and a parent could also choose to contribute to a 529 owned by their parent for the benefit of their child.

Will My Contributions Trigger Any Gift Tax?

Only up to $18,000 in 2024 may be contributed to a 529 plan by a donor until it starts to cut into the donor’s lifetime exclusion limit, which is currently $13.61MM per person. This limit doubles to $27.22MM for married couples. The lifetime exclusion limit is essentially the maximum amount that an individual may transfer in life or at death without incurring gift and estate taxes. However, transferring any amount of assets to a U.S. citizen spouse or qualified charity during life or at death will not reduce the lifetime exclusion amount or trigger any gift taxes.

Instead of paying any gift tax in the year of a transfer, contributions exceeding the applicable annual exclusion amount will need to be reported as taxable gifts. This will reduce the $13.61MM lifetime exclusion limit by the same amount. 

For example, if a $20,000 contribution is made to a 529 plan in 2024, the donor’s lifetime exclusion limit would be reduced by $2,000 (the amount exceeding the annual exclusion limit of $18,000). Note that the IRS tends to increase this exclusion amount every few years. 

What If I Want to Contribute More Than That in Year One?

Donors may also choose to front-load or “super fund” a 529 by contributing five years’ worth of contributions in a single year. For example, a donor may choose to contribute $90,000 ($18,000 x 5 years) all in the first year. This is almost the same as if the donor were to contribute $18,000 each year for five years. 

However, due to the time value of money, a larger lump sum contributed earlier may result in a higher ending account balance. A married couple may contribute up to $180,000 in year one of a five-year super fund strategy by electing gift splitting. A donor may also elect to contribute an amount less than the full annual exclusion amount while super funding. 

For example, a donor may want to contribute only $50,000 in year one. This would be spread out over five years for $10,000 per year (you cannot choose a shorter timeframe). Be mindful that a super funding donor contributing five years’ worth of the annual exclusion amount in year one may not contribute any additional funds to that particular 529 until the five years have passed. If they do, those funds will count against their lifetime exclusion of $13.61MM. 

If a donor contributes more than the annual exclusion amount, they must file a gift tax return (Form 709) that year. This is also true if a married couple elects gift splitting, even if the amount is less than the annual exclusion amount. Additionally, each spouse must file their own Form 709 since there is no such thing as a joint gift tax return. 

For example, a married couple gives $20,000 to a family member and elects gift splitting. Each spouse must file a Form 709 and list half of the gift’s overall value ($10,000) on their form. Since gift splitting is being elected, each spouse must file a Form 709, even though half of the gift’s total value does not exceed the annual exclusion amount of $18,000 in 2024. 

During a super funding scenario, the donor (or donors) must fill out a Form 709 during each of the five years. For example, a married couple decides that they would like to super fund their child’s 529 plan in year one. They could elect gift splitting and contribute the full $180,000 in the first year. They would then both need to file a separate Form 709 during each of the five years. Any additional contributions by either of them during this five-year period will be deemed a taxable gift and will reduce each of their lifetime exclusion amounts of $13.61MM.

Can Super Funding Help with Estate Planning?

Since the contribution is seen as a completed gift by the IRS, any funds transferred to the 529 plan are considered to be removed from the donor’s estate. This is true even if the donor is also the owner of the 529 plan. This unique treatment by the IRS can potentially make this a valuable estate planning technique to remove a large chunk of funds from an individual’s gross estate in a single year, especially for grandparents. 

As previously mentioned, a donor may elect to contribute five years’ worth of future contributions in a single year. It is important to understand that if a super funding donor passes away during the five-year period, only a portion of the total initial amount will escape the donor’s gross estate calculation. For example, if a grandparent super funds $90,000 in year one and then passes away in year three, only the first three years’ worth of annual exclusions ($54,000) will be removed from their gross estate. The last two years’ worth ($36,000) can remain in the 529 plan but will also be included in the donor’s gross estate calculation. Thus, to remove the entire amount that was super-funded, a donor must live for at least one day in the fifth calendar year. 

How Does a 529 Plan Work with Financial Aid?

Who owns the 529 plan will ultimately determine how financial aid is affected for a beneficiary. Most of the time, 529 plans will be considered an asset of the parent or grandparent instead of the child beneficiary. This is a good thing, as assets owned by a parent will only result in a benefit reduction for the student of up to 5.64% of the asset’s value at the time of applying for financial aid. This is much more attractive than the 20% reduction in benefits for assets owned directly by the student.

How Do Grandparent-Owned 529s Impact Financial Aid?

Grandparent-owned 529 plans are not reported on the student’s FAFSA form at all—another major plus. Additionally, The Consolidated Appropriations Act of 2021 resulted in the new “Simplified FAFSA,” which made grandparent-owned 529s even more advantageous. As a result, starting in 2024, 529 plans owned by grandparents will no longer have a negative effect on their grandchild’s financial aid benefits. 

More specifically, distributions from grandparent-owned 529s will no longer result in any reduction in benefits for the grandchild at all. Before the new Simplified FAFSA, distributions from grandparent-owned 529s would lead to a considerable reduction in financial aid benefits for the grandchild. These distributions were seen as “untaxed student income,” which could reduce benefits for the student by a whopping 50%. 

For example, a distribution from a grandparent-owned 529 of $20,000 would have potentially resulted in a benefit reduction of $10,000 for the student. Now, because of the new regulations, grandparents have a significant advantage by not only reducing their gross estate via 529 contributions but also by not having the distributions adversely impact the grandchild’s financial aid benefits. The new Simplified FAFSA rules may now make it more advantageous for grandparents to contribute to a 529 plan they own, as opposed to contributing to the grandchild’s parent’s 529, where the benefits can be reduced by 5.64% of the plan value.

Are 529 Plans Eligible for Tax Deductions?

There is currently no federal tax deduction for contributing to a 529 plan, regardless of which state you live in or which state’s plan you use. However, a state income tax deduction or credit may be available depending on what state you reside in. As of now, almost all states either have no state income tax or allow some sort of tax benefit to contribute to a 529 plan. A few states – California, Hawaii, North Carolina, and Kentucky – do have state income tax but do not provide any tax benefit for 529 plan contributions. This means that California taxpayers may not take a tax deduction for contributions made to a California 529 Plan (ScholarShare529) or any other state’s 529 plan. 

Taxpayers who are currently residents of other states may be eligible for a deduction or credit at the state level. Each state dictates who is permitted to take advantage of the deduction or credit for the contribution (donor, plan owner, etc.). Each state also differs on how much of a contribution can be applied towards a state deduction or credit. Taxpayers must check with their respective state’s tax guidelines for more information.

How Do Distributions Work?

Distributions from 529 plans are usually classified as either qualified or non-qualified.

Qualified distributions can be withdrawn completely income tax-free and are not subject to a 10% penalty. The distribution is on a pro-rata basis, meaning each distribution from the plan consists of part return of principal and part earnings. If it is a qualified distribution, both categories will be completely income-tax-free and penalty-free. 

Non-qualified distributions will be subject to income tax and a 10% penalty. The distribution is on a pro-rata basis, meaning each distribution from the plan consists of part return of principal and part earnings. Only the return of the principal portion will be income tax-free and penalty tax-free if it is a non-qualified distribution. The earnings portion, however, will be subject to income tax and a 10% penalty. California may also impose an additional penalty tax on the earnings portion (discussed below).

A Form 1099-Q will be issued each year listing all distributions from the 529 plan during the year.

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Can I Be Penalized for Pulling Money Out Too Early or Too Late?

529 plans do not have any Required Minimum Distributions (RMDs). This means that funds can stay in the plan well after the age that would usually trigger RMDs for an individual’s other retirement plans (401(k)s, 403(b)s, IRAs, etc.). This age is 75 for those who were born in 1960 or later. 

529 plans also do not have a 10% early withdrawal penalty like most retirement plans. This means that funds that have grown tax-deferred may be withdrawn from the plan before age 59 ½ without incurring the 10% penalty, as long as they are being used for qualified education expenses. 

What Makes a Distribution Qualified?

Qualified distributions are those that are used to pay for qualified education expenses. At a high level, these include:

  • Tuition and other required fees at any accredited public or private university, college, or community college
  • Books and other required supplies that are necessary for post-secondary enrollment
  • Room and Board during post-secondary enrollment
  • Computers, software, and related equipment during post-secondary enrollment
  • Tuition and other required fees/books at any K-12 institution (up to $10,000 per year)
  • Tuition and other required fees for certain apprenticeship programs approved by the Department of Labor
  • Qualified education loan repayment (lifetime maximum of $10,000 per person)

Some expenses that are related to education are not considered qualified education expenses when it comes to 529 plans. These expenses include:

  • Extracurricular activity expenses/fees
  • Sports or club fees
  • Transportation costs 
  • Any room and board costs in excess of what is listed by the college as their “cost of attendance.”

How Do Certain Tax Credits Impact 529 Distributions?

529 plans are subject to certain tax incentive coordination rules. These rules essentially mean that you cannot double dip by using the same qualified education expenses that you have already used to take advantage of either the American Opportunity Tax Credit (AOTC) or the Lifetime Learning Credit (LLC). 

For example, the AOTC requires $4,000 of qualified education expenses to receive the full $2,500 credit. These same $4,000 of education expenses would not be able to be accounted for again when withdrawing funds from a 529 plan. 

Double-dipped funds may be deemed a non-qualified distribution from the 529 plan, triggering taxation and penalties on the withdrawn earnings portion. On a related note, a taxpayer is also not permitted to take both the AOTC and the LLC in the same year for the same child. 

How Do Distributions for K-12 Expenses Work in California?

Up to $10,000 each year may be withdrawn from a 529 plan to cover expenses at a public, private, or religious elementary, middle, or high school. Unfortunately, California taxpayers will still be on the hook for California state income tax and an additional 2.5% tax when withdrawing funds for K-12 expenses. This means that the earnings portion of each pro rata withdrawal for K-12 purposes will be subject to state income tax and an extra 2.5% tax. Luckily, California taxpayers will still avoid paying any federal income tax and the 10% federal penalty on withdrawals for K-12 expenses. 

How Do Non-Qualified Distributions Work in California?

A non-qualified distribution will occur anytime a withdrawal is made for expenses that are not deemed qualified education expenses. If this occurs, the earnings portion of each pro rata distribution will be subject to federal income tax, state income tax, and a 10% federal penalty tax. In addition, California may impose an additional 2.5% penalty tax. Each of these taxes is imposed only on the earnings portion of each distribution, even if the distribution is a non-qualified one. Distributions of the original contributions are a return of principal and are never penalized or taxed again. 

Can I Avoid Paying the 10% Federal Penalty Tax?

Certain situations may allow a distribution to avoid paying the 10% federal penalty tax. These “taxable distributions” must be linked to:

  • The death of the beneficiary, or
  • The permanent disability of the beneficiary, or
  • The receipt of a scholarship by the beneficiary or
  • The attendance at a military academy by the beneficiary

Note: Any of the above scenarios will be deemed a “taxable distribution” but not necessarily a “non-qualified distribution.” This means that the earnings portion of each distribution will still be subject to federal and state taxation. However, since one of the exceptions applies, the entire distribution will avoid the 10% federal penalty tax and the 2.5% California penalty tax (for California residents). 

What if I Want to Change the 529’s Beneficiary?

Changing a 529 plan’s beneficiary can sometimes make sense. This is especially true if the original beneficiary decides not to go to college or if they already have and there are funds left over. You may want to use these leftover funds for a second child’s benefit. A change of beneficiary is permitted up to two times per calendar year and may be completed by the plan owner. 529 plans can only have one beneficiary at any given time. The new beneficiary also needs to be related to the original beneficiary. A change in beneficiary will not be a taxable event as long as the new beneficiary is an eligible family member related to the current beneficiary.                     

These eligible individuals include the current beneficiary’s:

  • Spouse
  • Children (or stepchildren)
  • Parents (or stepparents) 
  • Siblings (or stepsiblings)
  • Aunts or uncles (or their spouses)
  • Nieces or nephews (or their spouses)
  • First cousins (or their spouses)

Additionally, the plan owner is permitted to alter the plan’s investments when changing the beneficiary. This can be important if the new beneficiary’s time horizon is different from the last beneficiary’s. The plan owner (often the parent) can even make themselves the beneficiary.

How Often May I Alter My 529’s Investments?

The plan owner may change existing investments up to two times per calendar year and each time a beneficiary changes. While these limitations apply to funds already inside the plan, they do not apply to future contributions. Thus, the plan owner may change how future contributions are invested as often as they want.  

How Did SECURE ACT 2.0 Change 529 Plans?

In an effort to make saving for college via 529 plans more attractive, SECURE ACT 2.0 opened up a new option starting in 2024. Under the new guidelines, a 529 plan beneficiary can now roll over unused funds into their Roth IRA. However, there are a few requirements that must be met first:

  • The 15-Year Rule: The IRS has stated that the 529 plan must have been open for at least 15 years before a rollover to a Roth IRA is permitted. As of right now, it is unclear as to how a beneficiary change will affect this 15-year clock. If a beneficiary change does not restart the clock, this could become a valuable planning technique to get extra funds into a Roth IRA. The IRS is still needing to make an official ruling on this. 
  • Trustee-to-Trustee Only: Under the new guidelines, only trustee-to-trustee transfers are permitted. This means that funds being rolled from the 529 plan must be transferred directly to the new custodian where the Roth IRA is being held.
  • Beneficiary’s Roth IRA: In order for a rollover to be permitted, the receiving Roth IRA must also belong to the beneficiary of the 529 plan. No funds may be rolled over to a Roth IRA that does not also belong to the beneficiary of the 529. 
  • The 5-Year Lookback: Any contributions made in the last five years – and any earnings stemming from those contributions – are not eligible for a rollover. Simply put, any funds that are being rolled over must have been in the 529 plan for at least the last five years.
  • Lifetime Rollover Maximum: The total amount that can be rolled over is not unlimited. As of 2024, the lifetime maximum amount that can be rolled over is $35,000. Any additional funds left in the 529 above this threshold will not be permitted for a rollover.  
  • Annual Rollover Maximum: In addition to the lifetime rollover maximum, there is also an annual rollover maximum. This maximum aligns with that year’s regular IRA contribution limit. For 2024, this is $7,000 (or $8,000 if 50 or older) or the beneficiary’s earned income for that year, whichever is less. This annual rollover maximum will also be reduced by any regular contributions made during the year to the beneficiary’s Roth IRA or traditional IRA. For example, if the beneficiary already contributed $3,000 to their traditional IRA for the year, they would only be permitted to roll over $4,000 from their 529 plan (assuming the plan has been open for at least 15 years and that they have sufficient earned income for the year). However, unlike contributions to Roth IRAs, no AGI limits exist for 529 rollovers. This essentially means that individuals who would otherwise be ineligible for an ordinary Roth IRA contribution due to high income can still participate in the rollover. 

How Do Rollovers From 529s to Roth IRAs Work in California?

Each state is starting to interpret the new 529 rollover option in its own way when it comes to state taxation. As of 2024, these rollovers will be considered a non-qualified distribution for those individuals who file a California state income tax return. This means that each rollover from a 529 to a beneficiary’s Roth IRA will be subject to California state income tax and the extra 2.5% penalty tax. Both taxes will only apply to the earnings portion of each pro rata distribution. However, the rollover will still avoid any federal income tax and the federal 10% penalty tax. Taxpayers residing in other states must check with their state’s guidelines when contemplating a rollover to a Roth IRA. 

529 plans are a versatile and powerful tool for saving toward future education expenses. Whether for children, grandchildren, or even yourself, these plans offer significant tax advantages, contribution flexibility, and estate planning benefits. By understanding the nuances of contributions, gift tax implications, financial aid impacts, and recent legislative changes, you can maximize the benefits of a 529 plan.

As with any investment, staying informed and considering your circumstances and goals is vital. Consulting with a financial advisor can help you tailor the right strategy to align with your needs.

Need help leveraging the full potential of a 529 plan? We can help.

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