529 plan
A 529 plan, also called a Qualified Tuition Program,[1] is a tax-advantaged investment vehicle in the United States designed to encourage saving for the future higher education expenses of a designated beneficiary. In 2017, K–12 public, private, and religious school tuition were included as qualified expenses for 529 plans along with post-secondary education costs after passage of the Tax Cuts and Jobs Act.
529 plans are named after section 529 of the Internal Revenue Code—26 U.S.C. § 529. While most plans allow investors from out of state, there can be significant state tax advantages and other benefits, such as matching grant and scholarship opportunities, protection from creditors and exemption from state financial aid calculations for investors who invest in 529 plans in their state of residence. Contributions to 529 college savings plans are made with after-tax dollars. Once money is invested in the account, it grows tax-free, and withdrawals from the plans are not taxed when the money is used for qualified educational expenses.[2] Only 2.5 percent of all families had 529 college savings accounts in 2013.[3] As of August 2020, more than $360 billion was invested in 529 college savings plans.[4]
There are two types of 529 plans: prepaid plans and savings plans.
With the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), 529 plans gained their current prominence and tax advantages. Qualified distributions from 529 plans for qualified higher education expenses or tuition for elementary or secondary schools are exempt from federal income tax.[7]
History[edit]
529 college savings plan originated from states rather than the federal government. With tuition cost increasing year by year, the state-run prepaid tuition program of Michigan addressed the increasing anxiety on the part of many thousands of Michigan households with the Michigan Education Trust (MET) proposition. This created a fund to which the state's residents could pay a fixed amount in exchange for tuition increases. The initiative sparked interest in other states, which launched their first prepaid tuition program.
Michigan delayed its own launch so that a ruling could be requested from the Internal Revenue Service (IRS) regarding the tax aspect of arrangement. The IRS allowed purchasers of the "prepaid tuition contract" to not be taxed on the accruing value of the contract until the year in which funds were distributed or refunded. Additionally, the trust fund established by the state of Michigan was required to receive prepayments and be subject to income tax on earnings from the invested funds.
The Michigan Education Trust (MET) entered into prepaid tuition contracts with Michigan's residents. An estimated 55,000 individuals signed up for the program. MET paid federal income tax on its investment earnings, and in 1990 filed suit for refund from the IRS. The case was first decided in favor of the IRS, but on appeal in 1994 the Sixth Circuit Court of Appeals reversed the district court judge's decision and found in Michigan's favor.
At one point MET sold prepaid tuition contracts that were below market value, and the program had to be adjusted with appropriate pricing. Today it remains as one of the largest and most successful pre-paid programs.
Subsequently, Congress has passed new legislation authorizing qualified state tuition programs. This is now part of the Small Business Job Protection Act of 1996. Section 529 was added to the Internal Revenue Code, conferring tax exemption to qualifying state programs and deferring tax on participant's undistributed earnings.
Section 529 advanced to the Clinton administration's agenda and became part of Taxpayer Relief Act of 1997 (TRA). The TRA made changes such as deduction on student loans, penalty-free IRA withdrawals for higher education, and adding room and board to the list of qualifying expenses.
Another provision was added to the bill to make Section 529 distributions tax-free, not just tax deferred when used for college. Bill Clinton vetoed this provision.
In 2001, when George W. Bush was president, new tax bills were crafted in both the Senate and the House of Representatives containing the previously vetoed changes.
With limited Democratic support,[8][9] the Economic Growth and Tax Relief Reconciliation Act (EGTRRA) of 2001 was signed into law on June 7, 2001.[10]
Due to federal budget constraints, EGTRRA stated that every tax provision within the new law would expire on December 31, 2010. Congressional leaders decided to insert a provision in the Pension Protection Act of 2006 (PPA) that would make all EGTRRA charges to Section 529 permanent, including tax-free treatment for qualified distributions.
Changes to the structure and marketing of 529 plans over the years have contributed to their growth. The states partnered up with the professional investment community, which allowed them to offer 529 plans with the feel of mutual funds. Also, registered brokers and investment advisors can directly assist families in understanding 529 plans and selecting an appropriate investment.
Other changes that have resulted in a growth in adoption include: federal legislation regarding taxes, financial aid, asset protection; on-going program improvement; lowering of expenses; generous state incentives; positive media coverage; and college savings registries that allow people sign up for the program.[11] Some employers offer 529 plans to their employees as a benefit, similar to retirement plans, or even with contribution matching.[12]
In 2014, Congress passed the Achieving a Better Life Experience (ABLE) Act, laying the groundwork for ABLE accounts. ABLE, or 529A, accounts are similar to 529 plans, except for the purpose of saving for a disabled beneficiary's special needs.[13]
In his 2015 State of the Union address, President Obama proposed removing the tax-free status of distributions of 529 plans. He abandoned the proposal after it met with heavy opposition.[14]
The Tax Cuts and Jobs Act of 2017 heavily expanded 529 plans to include K–12 public, private, and religious school tuition. The original plan, called the Cruz amendment, called for homeschool expenses to also qualify for 529 plans but due to the Byrd Rule in the Senate the homeschool expenses provision was stricken by the Senate parliamentarian while the K–12 tuition provision was allowed. According to the new law 529 plans can be used to fund all K–12 school tuition costs up to $10,000 per year per child.[15] The SECURE Act further expanded the use of 529 plans to cover student loan repayments.[16] The Tax Cuts and Jobs Act also allowed rollovers from 529 plans to ABLE accounts, as long as the ABLE account beneficiary is the original 529 beneficiary or a qualified family member. The allowed annual rollover amount is set at the standard IRS gift tax exemption, less any other contributions made in the current tax year.[17]
Secure ACT 2.0 of Jan 2023 allows for tax and penalty free rollovers from 529 accounts to Roth IRAs, under certain conditions. Beneficiaries of 529 college savings accounts would be permitted to rollover up to $35,000 over the course of their lifetime from any 529 account in their name to their Roth IRA. These rollovers are also subject to Roth IRA annual contribution limits, and the 529 account must have been open for more than 15 years.[18]
The funds from a 529 plan are used for qualified education expenses. These expenses are typically tuition, fees, textbooks, computers and equipment and are charged to the student in relation to attending an institution defined as any eligible public, non-profit or private college or university, technical, vocational, or trade institutions. Expenses for special needs services needed by a special needs beneficiary must be incurred in connection with enrollment or attendance at an eligible post-secondary school or institution as described previously. For expenses to qualify, the student must be enrolled for at least half the full-time academic workload for the course of study the student is pursuing, as determined under the standards of the school where the student is enrolled. Institutions are considered eligible if they participate in a financial aid program administered by the U.S. Department of Education. This may also include some foreign educational institutions located outside of the United States, but they must be eligible to participate in a financial aid program administered by the U.S. Department of Education as well.
Additionally, as determined by state law, eligible expenses of no more than $10,000 of tuition incurred by a designated beneficiary enrolled in elementary or secondary school may be used at any eligible public, private or religious school that provides elementary or secondary education.[1]
Room and board are also considered eligible expenses for both on-campus and off-campus housing. For on-campus housing – the expense allowed is the actual amount charged if the student is residing in housing owned or operated by the school. For off-campus housing – the expense is allowed up to the amount allowed for on-campus room and board, as determined by the school, that was included in the cost of attendance (for federal financial aid purposes) for a particular academic period and living arrangement of the student.[1] 529 plan qualified expenses for off-campus housing are not limited to rent. They can include groceries and utilities. For tax purposes, receipts for all qualified expenses must be kept.[19]
Recent changes now allow expenses for fees, books, supplies, and equipment required for the designated beneficiary's participation in an apprenticeship program registered and certified with the Secretary of Labor under section 1 of the National Apprenticeship Act to be considered eligible expenses.[20]
Qualified education expenses formerly did not include student loans and student loan interest. However, on December 12, 2019, the SECURE Act was signed into law, which allows for 529 withdrawals for "principal or interest on any qualified education loan", under certain conditions:[21]
A distribution from a 529 plan that is not used for the above qualified educational expenses is subject to income tax and an additional 10% early-distribution penalty on the earnings portion of the distribution. The tax penalty is waived if any of the following conditions is satisfied:
Disadvantages[edit]
While the number and types of 529 plans are growing, not all investment vehicles are available in 529 form.
Unlike almost all other types of tax-deferred plans, such as 401(k) plans, IRS rules allow only two exchanges or reallocation of assets per year in a 529 plan. This limitation also applies to ABLE accounts.
The earnings portion of money withdrawn from a 529 plan that is not spent on eligible expenses (or rolled over into an ABLE account for any eligible family member) is subject to income tax, an additional 10% federal tax penalty, and the possibility of a recapture of any state tax deductions or credits taken. For example, if $50,000 is contributed to a 529 plan, where it grows to $60,000 over time, and an unqualified withdrawal is made for the entire amount, the $10,000 gain is taxable and a 10% penalty on the $10,000 is applicable (i.e. $1,000).
Paying qualified expenses directly from a 529 account that is owned by someone other than the student or parent may reduce a student's eligibility for need-based financial aid.[25]
Paying college expenses directly from a 529 account may reduce eligibility for the American Opportunity Tax Credit, due to IRS coordination restrictions. To claim the full credit (in addition to meeting other criteria, such as income limits), $4,000 of college tuition and textbook expenses per year should be paid from non-529 plan funds.[26]
The 529 plan for the state in which one is domiciled may have higher fees (expense ratios) – which are not required to be disclosed in marketing materials and can range from under 0.4% to more than 1.1% – than the plans of other states. For example, a 529 plan in which $2,000 is deposited each year for 18 years would accumulate over $4,000 in fees with a 1.1% expense ratio but only $1,400 in fees with a 0.4% expense ratio – a savings of $2,600. Generally, direct-sold 529 plans have lower fees than advisor-sold 529 plans.[27]
Deductibility of losses[edit]
In certain circumstances where a 529 account has experienced investment losses over the term of its existence, the contributor to the account may withdraw the funds and have the losses deducted from taxable income (but not counted as such for Alternative Minimum Tax purposes).[28]
Gift tax considerations[edit]
Contributions to 529 plans are considered gifts under the federal gift tax regulations and hence any contributions in excess of $15,000 if filing single (or $75,000 over five years) or $30,000 if filing married jointly (or $150,000 over a five-year period) count against the one-time gift/estate tax exemption. The five-year period is known as the five-year carry-forward option: Once the single donor puts in $75,000 or the married jointly donor puts in $150,000, they are not able to make another contribution (gift) to that individual (without using part of their lifetime gifting exclusion) for five years.[29]
Since tuition payments to an educational institution are not subject to the annual gift limitation, parents who are trying to minimize estate taxes may be better off making their annual gifts to another vehicle such as a Uniform Transfers to Minors Act (UTMA) account and then paying the tuition directly. However, this may significantly reduce the student's eligibility for need-based financial aid.