This year, not only is Memorial Day being celebrated on May 29, but it is also the date for an unofficial holiday, “529 Day.” Several states are marking the occasion by offering chances to win extra money for college. For example, anyone who opens a new Pennsylvania 529 Guaranteed Savings Plan account for a new beneficiary before May 31, 2023, will be entered for chance to win $5,290. Click here for the official rules for PA, and click here for details about promotions in other states.
Even if you don’t enter one of these contests, all taxpayers can win tax savings opportunities when contributing to a 529 Plan. This post will provide an overview of the different types of plans and how they work, the potential tax savings benefits and other matters to consider related to choosing the right plan.
What Is a 529 Plan?
Are you worried about not being able to come up with the funds to afford higher education expenses as the tuition rates keep rising? A 529 Plan is designed to help ease your concerns and, as an added bonus, provides tax savings opportunities for both the contributors and beneficiaries of the accounts.
A 529 Plan is an investment account that offers tax benefits when used to pay for qualified education expenses for a designated beneficiary. The funds can be used to pay for college, K-12 tuition, apprenticeship programs, and student loan repayments. The most common type of 529 Plan is a College Saving Plan, which offers several investment options to choose from. Some states have the option of pre-planned investment portfolios or allow you create your own by choosing your investment profiles.
Think of a 529 College Savings Plan like a Roth-IRA – it will be funded using after-tax income, which will earn interest and can be taken out of the plan tax-free if used for qualified education expenses. This funding will have no impact on the beneficiary’s state financial aid, so if started early, a 529 College Savings Plan is a great way to begin compounding your contributions before the beneficiary heads off to school.
The plan can be set up by anybody who is a family member of the beneficiary. The beneficiary can have more than one 529 Plan, but contributions cannot exceed an aggregate amount, which is set by the state and could be as high as $550,000. Once that maximum is reached, the plan will still accrue earnings but additional contributions cannot be made to the plan. Contributions to a 529 plan are considered completed gifts for federal tax purposes, and in 2023 up to $17,000 per donor, per beneficiary qualifies for the annual gift tax exclusion. Excess contributions above $17,000 must be reported on IRS Form 709 and will count against the taxpayer’s lifetime estate and gift tax exemption amount ($12.92 million in 2023). A larger tax-free 529 contribution can be utilized as part of an estate planning strategy if certain requirements are met. Please contact GYF for assistance.
While all states offer a 529 College Savings Plan, only some states offer a 529 Prepaid Tuition Plan (Click here for info about the PA Guaranteed Savings Plan). This plan allows all or part of the costs of an in-state public college education to be paid in advance at the current rate by purchasing units or credits. The funds in these accounts can also be converted for use at private and out-of-state colleges. The Private College 529 Plan is a separate prepaid plan sponsored by more than 250 private colleges. Educational institutions can also offer prepaid tuition plans for their own schools. Click here for more information about this type of plan.
What Are the Tax Benefits?
Contributions made to a 529 plan grow tax-free, and taxpayers do not pay ordinary income taxes on those amounts, as long as the funds are spent on qualified education expenses. The contributions cannot be taken as federal tax deductions, but 30+ states (and the District of Columbia) allow state tax credits or deductions. Click here for a comprehensive list.
Nine states (Alaska, Florida, New Hampshire, Nevada, South Dakota, Tennessee, Texas, Washington and Wyoming) have no income tax and, thus, no 529 deduction can be taken in those states. Additionally, six other states (California, Delaware, Hawaii, Kentucky, Maine and North Carolina) do not offer a tax deduction for funds invested in a 529 plan.
Five states (Indiana, Minnesota, Oregon, Utah and Vermont) provide tax credits, which can be used to offset the taxpayers’ state income taxes. In general, these credits, offer greater tax savings to a wider range of taxpayers than deductions. The remaining states (and the District of Columbia) allow taxpayers to deduct their 529 contributions from their taxable income calculation, subject to deduction limitations.
Colorado, New Mexico, South Carolina and West Virginia, allow taxpayers to deduct 100% of 529 plan contributions from state taxable income. Other states limit the amount of contributions that are eligible for a state income tax benefit. Pennsylvania offers one of the highest deduction limits per beneficiary – residents can claim a $17,000 per beneficiary tax deduction ($34,000 if married filing jointly) for 2023, which is in conjunction with the gift tax limitation for 2023.
Pennsylvania is also one of nine states (Arizona, Arkansas, Kansas, Maine, Minnesota, Missouri, Montana, Ohio and Pennsylvania) that offers tax parity, which means that contributions to any 529 plan (not just the in-state plan) qualify residents for an annual state income tax benefit credit or deduction. See this Morningstar article for details about parity and other state-related considerations that may impact your choice of where to start a 529 plan.
What Expenses Can I Pay with the Earnings from the Plan?
If the distributions are taken out of the plan and used for qualified education expenses, the distributions will be tax-free to the beneficiary. Qualified expenses consist of tuition, room and board, required books and supplies, which include tablets, computers, printers, and educational software. The distributions may also be used to pay interest and principal on qualified education loans that are in repayment, up to $10,000 per individual. For beneficiaries who are attending a college, university, graduate, or vocational school there is no distribution limitation; however, for beneficiaries who are K-12 students in private, public, or religious schools, there is a $10,000 distribution limitation per beneficiary across all accounts.
What If the Beneficiary Chooses Not to Go to College?
529 plans offer a lot of flexibility about who can use the plan and when they can use it. As long as the 529 plan beneficiary is living, the account can stay open and the beneficiary of the plan can be changed at any point. This means that an original beneficiary could change his/her mind and go back to school later in life, could name his/her own children as the new beneficiaries of the plan, or transfer the funds to a qualified family member. The person who originally opened the plan could also rename himself/herself as the beneficiary and use the funds for education. We would suggest opening an account per child for ease of use for educational purposes, and if one beneficiary chooses not to use the account it can be transferred to another beneficiary within the family.
The SECURE 2.0 Act of 2022 included a provision that allows distributions from 529 plans to Roth IRAs, further alleviating some of the concerns of those who are unsure what the future holds related to educational plans. Under this new rule, which takes effect in 2024, college savings can be transferred to a beneficiary’s retirement savings account without taxes or penalties. Click here for more details about the rules and limitations for these transfers.
Additional options for those who do not go to college include the ability to withdrawal up to $10,000 to pay for qualified loans of the beneficiary or their siblings, or to simply withdrawal the remaining funds for nonqualified use. Withdrawals made for nonqualified use will result in any allocated earnings of the distributions to be included in the gross income of the beneficiary and a 10% penalty being applied to those earnings (the penalty is waived in certain circumstances).
Final Thoughts
529 Plans are low-maintenance investments that offer a wide range of tax benefits. If you would like to discuss the various options or have any additional questions about 529 plans, please contact your GYF Tax professional at 412-338-9300.
