A 529 plan is a tax-advantaged investment vehicle in the United States designed to encourage saving for the future higher education expenses of a designated beneficiary.

Overview of 529 Plans

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.

There are two types of 529 plans, prepaid plans and savings plans.

Prepaid Plans allow one to purchase tuition credits at today’s rates to be used in the future. Therefore, performance is based upon tuition inflation. Prepaid plans may be administered by states or higher education institutions.

Savings Plans are different in that all growth is based upon market performance of the underlying investments, which typically consist of mutual funds. Most 529 savings plans offer a variety of age-based asset allocation options where the underlying investments become more conservative as the beneficiary gets closer to college age. Savings plans may be administered by states only. Although states administer savings plans, record-keeping and administrative services for many savings plans are usually delegated to a mutual fund company or other financial services company.

Use for qualified education expenses

Money from a 529 plan can be used for tuition, fees, books, supplies and equipment required for study at any accredited college, university or vocational school in the United States and at some foreign universities.

The money can also be used for room and board, as long as the fund beneficiary is at least a half-time student. Off-campus housing costs are covered up to the allowance for room and board that the college includes in its cost of attendance for federal financial-aid purposes.

Qualified education expenses do not include student loans and student loan interest.

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 gains portion only unless one of the following conditions is satisfied:

  • The designated beneficiary dies, and the distribution goes to another beneficiary or to the estate of the designated beneficiary.
  • The designated beneficiary becomes disabled. A person is considered disabled if there is proof that he or she cannot do any substantial gainful activity because of a physical or mental condition. A physician must determine that the individual’s condition can be expected to result in death or continue indefinitely.

The designated beneficiary receives any of the following:

  • a qualified scholarship excludable from gross income
  • veterans’ educational assistance
  • employer-provided educational assistance
  • any other nontaxable payments (other than gifts, bequests or inheritances) received for education expenses

Advantages

There are many advantages to the 529 plan.

Although contributions are not deductible from the donor’s federal income tax liability, many states provide state income tax deductions for all or part of the contributions of the donor. Beyond the potential state income tax deduction possibilities, a prime benefit of the 529 plan is that the principal grows tax-deferred and distributions for the beneficiary’s college costs are exempt from tax.

Many states give the account owner a full or partial state income tax deductions for their contributions to the state’s section 529 plans. Contributions to other states’ section 529 plans are generally not deductible in your home state.

The donor maintains control of the account. With few exceptions, the named beneficiary has no rights to the funds. Most plans even allow you to reclaim the funds for yourself any time you desire, no questions asked. However, if a “non-qualified” withdrawal is made, the earnings portion will be subject to income tax and an additional 10% penalty tax.

A 529 plan can provide a very easy hands-off way to save for college. Once one decides which 529 plan to use, one completes a simple enrollment form and makes a contribution (or signs up for automatic deposits). The ongoing investment of the account is handled by the plan, not by the donor. Plan assets are professionally managed either by the state treasurer’s office or by an outside investment company hired as the program manager. The donor will not receive a Form 1099 to report taxable or nontaxable earnings until the year of the withdrawals. If an investment switch is desired, donors may change to a different option in a 529 savings program every year (program permitting) or the account may be rolled over to a different state’s program provided no such rollover for the beneficiary has occurred in the prior 12 months. 529 plans generally have very low minimum start-up and contribution requirements. The fees, compared with other investment vehicles, are low, although this depends on the state administering the plan. Finally, everyone is eligible to take advantage of a 529 plan, and the amounts that can be put in are substantial (over $300,000 per beneficiary in many state plans). Generally, there are no income limitations or age restrictions.

A final rather unusual advantage of the assets in a 529 plan is that although they can be reclaimed by the donor (subject to income tax and the 10% additional penalty on any gains) the assets are not counted as part of the donor’s gross estate for estate tax purposes. Thus 529 plans can be used as an estate planning tool to move assets outside of one’s estate while still retaining some measure of control if the money is needed in the future. A beneficiary must be designated and the income tax savings are still only obtained if the money is eventually spent for education, though in some cases estate taxes can be reduced without spending the money on education.

In addition, under the College Cost Reduction and Access Act of 2007, 529 college savings plans and prepaid tuition plans are now treated as an asset of the account owner (typically the parent), meaning they have little impact on a student’s eligibility for financial aid.

Transferable

Another benefit associated with 529 Plans is the ability to transfer unused amounts to other qualified members of the beneficiary’s family without incurring any tax penalty. According to the IRS website (Publication 970), this type of transfer is known as a Rollover and is explained at length in their Qualified Tuition Program (QTP) section. Any amount paid to another QTP within 60 days of distribution is considered Rolled Over & does not require reporting anywhere on Form 1040 or 1040NR.

Qualified members of the beneficiary’s family include the beneficiary’s:

  • Spouse
  • Son, daughter, stepchild, foster child, adopted child, or a descendant of any of them.
  • Brother, sister, stepbrother, or stepsister.
  • Father or mother or ancestor of either.
  • Stepfather or stepmother.
  • Son or daughter of a brother or sister.
  • Brother or sister of father or mother.
  • Son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, or sister-in-law.
  • The spouse of any individual listed above.
  • First cousin.

Disadvantages

While the number and types of 529 plans is growing, not all investment vehicles are available in 529 form.

Unlike other types of tax-deferred plans, such as 401(k) plans, IRS rules allow only a single exchange or reallocation of assets per year in a 529 plan.

The earnings portion of money withdrawn from a 529 plan that is not spent on eligible college expenses will be 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 you contribute $50,000 into a 529 plan and it grows to $60,000 over time and you make an unqualified withdrawal for the entire amount, you are taxed on the $10,000 gain plus a 10% penalty on the $10,000 which would be $1,000 penalty.

Paying tuition directly from a 529 account may reduce a student’s eligibility for need-based financial aid.

Paying college expenses directly from a 529 account may reduce eligibility for the American Opportunity Tax Credit. To claim the full credit (in addition to meeting other criteria, such as income limits), $4,000 of college expenses per year should be paid from non-529 plan funds.

Deductibility of losses

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).

Gift tax considerations

Contributions to 529 plans are considered gifts under the federal gift tax regulations and hence any contributions in excess of $14,000 if filing single (or $70,000 over five years) or $28,000 if filing married jointly (or $140,000 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 $70,000 or the married jointly donor puts in $140,000, they are not able to make another contribution (gift) to that individual (without using part of their lifetime gifting exclusion) for five years.

Since tuition payments 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.