Changes to the Tax Law Make Section 529 Plans Attractive Way to Save for
August 2001
Over the years the U.S. Congress has given taxpayers a variety of tax-advantaged ways to save and pay for higher education, including Education IRAs, HOPE scholarships and prepaid tuition plans. One particularly effective program is the college savings plan, commonly referred to as a "Section 529" plan. Since Congress added the 529 plan to the law in 1996, most states have established at least one 529 plan. Recent tax law changes will likely expand the number of plans and the tax benefits available under the plans. This On the Subject… describes Section 529 plans and how clients can use these plans to effectively save for higher education expenses.
What Is a Section 529 Plan?
A Section 529 plan is a tax-advantaged investment savings account for saving for higher education expenses run by a state or, starting in 2002, by any higher education institution. A person, or the "owner," establishes an account with the state the owner selects, deposits cash in the account and designates a beneficiary of that account. Until the beneficiary reaches college age, the plan invests the money in the account, and its earnings and growth during that time are not subject to federal income tax. When the beneficiary reaches college age, the funds in the beneficiary’s account are generally used to pay expenses of the beneficiary’s higher education at any college or university, not just one in the state that sponsors the plan. Starting on January 1, 2002, amounts withdrawn for certain educational expenses will not be subject to income tax. Amounts not used for educational expenses are subject to income tax when the assets from the account are withdrawn or when the account is closed.
How Do I Set Up an Account with a 529 Plan?
A parent or grandparent, or any other donor, may establish an account with a 529 plan simply by contributing cash to the plan and designating a beneficiary of the account. Most states permit nonresidents to set up accounts under their 529 plans.
How Much Can I Contribute to a 529 Plan Account?
Unlike an Education IRA, which has an annual contribution limit of $2,000, Congress did not limit a person’s annual contributions to a 529 plan account. Congress did, however, require each state to set a total contribution limit based on the average cost of attending college, either public or private, in that state. Contribution limits on accounts in some states exceed $100,000. You can establish accounts with more than one state, and, theoretically, contribute up to the maximum in each state. Doing so, however, could exceed the projected cost of the designated beneficiary’s higher education expenses and possibly trigger IRS scrutiny.
A contribution to an account under a 529 plan is a gift to the designated beneficiary for gift tax purposes. The gift, however, qualifies for the $10,000 gift tax annual exclusion. A special rule allows a person to contribute $50,000 in one year to a 529 plan account on behalf of a particular beneficiary and elect to treat the gift as made in the current year and each of the following four years. This ability to "forward average" the initial contribution for gift tax purposes allows a person to set aside a large amount that will enjoy the benefits of tax-free growth. The price of the forward averaging, however, is that the donor cannot make annual exclusion gifts to the beneficiary of the 529 plan account during the following four years without using gift tax exemption or paying gift tax. In addition, if the donor dies during the succeeding four-year period, a fraction of the gift amount will be included to the donor’s estate for federal estate tax purposes. The donor’s estate, however, does not include any income and appreciation on the "recaptured" contribution.
How Will the 529 Plan Invest the Account Assets?
Neither the person who sets up an account with a 529 plan (the owner) nor the plan’s beneficiary can direct the way in which the plan invests the contributed funds. Many states, however, have contracted with nationally known investment managers to manage funds in the states’ 529 plans. The investment of 529 plan account assets often reflects an asset allocation based on the beneficiary’s age, emphasizing growth investments when the beneficiary is young and more conservative investments as the beneficiary reaches college age. Some plans permit the owner to select from more than one age-based asset allocation. Some plans also permit the owner to select one or more specific mutual funds in lieu of the age-based asset allocation model. In all cases, the owner cannot change the asset allocation after he or she establishes the account other than by moving the plan assets to a 529 plan maintained by another state.
Are the Earnings on the Account Assets Subject to Income Tax?
The earnings on assets held in a 529 plan are not subject to federal income tax. The earnings may also be exempt from state income tax, though often states limit that benefit to residents of the state who invest with the state’s plan.
Who Determines How the Account Funds Are Used?
Section 529 plans typically allow only the owner to withdraw assets from an account or to direct the plan to pay the assets on behalf of the beneficiary. As a result, the owner, rather than the beneficiary, controls how the funds in the account are used. Congress intended that the owner use the account assets for the beneficiary’s tuition, room and board. Congress did not limit the amount of money that could be used for tuition, but it did limit expenditures for room and board to "reasonable" expenses. It is important to note that nothing in the law prohibits the use of account assets for purposes other than education, although, as discussed below, doing so may give rise to income tax and a penalty.
Are Withdrawals from 529 Plans Subject to Income Tax?
Under current law, amounts withdrawn from a 529 plan account are taxable income to the recipient. Starting on January 1, 2002, however, amounts withdrawn or distributed from a 529 plan account and used for qualified higher education expenses are not subject to federal income tax. Qualified higher education expenses include tuition and limited room and board. Many states also defer state income tax for state residents, and several states even offer state income tax deductions for contributions to the account.
Any withdrawals not used for qualified higher education expenses are included in the owner’s taxable income, less the owner’s contribution. Thus, the owner can recover his or her contribution tax-free but will be subject to income tax on the growth of the contribution. The government also imposes a 10 percent penalty tax on withdrawals from 529 plan accounts not used for the beneficiary’s higher education expenses. If, however, the beneficiary dies, becomes disabled or receives a scholarship, the penalty tax will not apply if the owner withdraws the account assets.
Can I Change the Beneficiary of a 529 Plan Account?
If the beneficiary chooses not to attend college or does not use all the assets in the account, the owner may transfer the account to another beneficiary without incurring federal income tax if the new beneficiary is a member of the previous beneficiary’s family. Family members for this purpose include children, grandchildren, siblings, stepchildren, stepsiblings, first cousins, parents, grandparents, stepparents, aunts and uncles, in-laws and spouses of those relatives. The transfer, however, will be a deemed gift by the beneficiary of the account if the new beneficiary is one or more generations below the original beneficiary (though the gift will qualify for the annual exclusion). The "donee" beneficiary can elect to use the five year forward averaging described above for annual exclusion purposes to reduce or eliminate the gift tax consequences of the deemed gift.
