At this time of year, I like to share some common questions that I typically get regarding 529 savings plans and those that arise as a potential estate plan technique that utilize 529 savings plan accounts. Before we get to the questions, let’s take a look back.
In 1996, Congress pushed for federal tax relief for college savings plans. That push led to the creation of Section 529 of the Internal Revenue Code and 529 plans.
In 2001, 529 plans were made more attractive when taxation on qualified withdrawals was fully eliminated as part of the 2001 tax overhaul.
Since 2002, assets in 529 plans have grown from $18 billion to $425 billon, securing it as the preferred vehicle for people saving for education.
What Makes These Accounts Special
Contributions to 529 plans grow tax-deferred. Earnings are tax-free only when the money is used to pay for qualified education expenses like tuition, fees and other related expenses.
When withdrawals are not used for qualified education expenses, the earnings are taxed at the recipient’s (usually the account owner or the beneficiary) tax rate and subject to a 10% penalty. In addition, if you wanted to contribute to an existing 529 account that is already set up, and you are not the owner, you can do that.
Most plans have a lifetime limit of $350,000 and up with limits varying by state. College America, for example, allows for contributions until the account value hits $500,000.
There is an estate planning advantage in the form of accelerated gifting with 529 savings plans and a favorable way for grandparents to contribute to their grandchildren’s education while paring down their own estate.
Under special rules unique to 529 plans, a lump-sum gift of up to five times the annual gift tax exclusion amount, which is $15,000 in 2021, is allowed in a single year. This means you could make a lump-sum gift of up to $75,000, ($150,000 for married couples) with no gift tax being owed. That is, provided the gift is treated as having been made in equal installments over a five-year period, and no other gifts are made to that beneficiary during the five years.
Multiple Usages, Multiple Plans
You might be surprised to learn you can open up as many 529 accounts as you’d like and make an accelerated gift to each account. This allows for the removal of assets from your estate. With the potential for changes to gift and estate tax laws, this could be a benefit to your heirs. Obviously, to get the most benefit, these funds should be used for education. However, even if you don’t use the money for education, for whatever reason, these accounts can be passed on to future generations that can use it for their education expenses. One final note, if the donor was to pass away after making an accelerated gift, a portion of the funds will be included in the donor’s estate for tax purposes.
Money in a 529 savings plan can be used to pay the full cost of tuition, fees, room, board, books and supplies at any accredited college or graduate school in the U.S. or abroad. It can also be used for certified apprenticeship programs (fees, books, supplies, equipment), for
K-12 tuition expenses up to $10,000 per year and for student loan repayment.
While 529 plans are governed by federal law, and each state implements their own plan, you can contribute to any state’s plan. States can offer tax benefits to residents that contribute to their own 529 plans, or like in Pennsylvania, where contributions of up to $15,000 are state tax deductible. This is available regardless of which state’s 529 plan you contribute.
Each institution that runs a 529 plan offers investment options ranging from traditional mutual funds to target date mutual funds. Target date funds for college operate like those designated for retirement in that they are designed to gradually allow for the investments to transition to a more conservative allocation as the time to withdrawal draws nearer. Typically, this is around the beneficiary’s college start date.
Flexibility and Ease of Use
Regarding investments, under federal law you are allowed to exchange your existing plan investments for different investments only twice per year. If one was to make more than two changes in a calendar year, the amount reallocated is treated as a withdrawal from the plan and earnings may be treated as income and subject to a 10% penalty.
Here some common questions we receive:
“What if the child gets a scholarship?”
This is a common concern. If they are fortunate enough to receive a scholarship, you can withdraw up to the amount of the scholarship without being assessed the 10% penalty. The earnings would, however, be subject to income tax.
“Who should own the 529 account?”
For financial aid purposes, 529 savings plans are considered an asset of their owner. Here is the most common scenario where parents own the account. Here, the account is treated as a parental asset for financial aid calculations. Essentially, this means that 5.64% of the value of the plan is counted toward the Expected Family Contribution (EFC) on their Federal Student Aid form or FASFA. As long as distributions are used for qualified expenses, they are not counted as income for FAFSA purposes. This would also apply if a dependent child owned the account.
If an independent student owns the account, it is treated as a student asset for financial aid calculations. This causes 20% of the account balance to count toward the student’s EFC on their FAFSA. Qualified distributions from the account would still not be included as income.
“What if the account is owned by someone that isn’t the parent or student, like a grandparent?”
In this case, the account is not counted as an asset for financial aid calculations for FASFA purposes. It is, however, treated as income to the student when distributions are made from the plan, which can hurt eligibility for financial aid.
That being said, FAFSA uses two years’ prior tax returns in their calculations, so the 2021-2022 FASFA form only requires your 2019 tax information. Given this, any qualified distributions from the plan that would be considered as income to the student in their junior and senior years (assuming graduation in 4 years) may not affect future financial aid.
For this reason, plans owned by grandparents are best used in the student’s last years of college. This also assumes they are receiving financial aid.
Finally, since we were discussing financial aid, the Biden administration has recently extended the suspension on federal student loan payments set to expire the end of September 2021 until January 31, 2022. This moratorium was initiated in March 2020 and has been extended three times. However, according to the Education Department this will be the last extension.
To be clear, this is just for federal loans, like Stafford, Grad PLUS and consolidated loans. If you have any loans held by the Department of Education, these loans pause programs will occur automatically. Also, this extension applies to those in the Public Service Loan Forgiveness program.
If you, or someone you know, would like more information, or if you just want to find out if you qualify, can go to studentaid.gov to check it out.