5 Tax Advantages of 529 Plans

Ah college. A chapter in our life where we can restart, redefine our path, leave the nest, and be free and independent, albeit shackled by the looming doom of student loans.

Based on statistics, the total of student loan debts in the U.S. is $1.762 trillion and the average debt per borrower continues to increase. Furthermore, 50% of student borrowers still owe at least $20,000 each after 20 years from entering school. By this time, they’d already have children of their own who are going to college.

Good news is, as parents (or grandparents), there are many ways for us to save up for our children’s college education, one of which is to invest in 529 plans which offer a two-pronged advantage: college savings for your designated beneficiary and special tax benefits for yourself.

What Are 529 Plans?

529 plans, legally known as “qualified tuition plans,” are named after Section 529 of the U.S. Tax Code. These are savings plans sponsored by states, state agencies, or educational institutions that offer special tax benefits like deduction of contributions from state income tax, exemption of earnings from federal income tax and, in most cases, from state income tax. There are two types of 529 plans: Prepaid Tuition Plans and Education Savings Plans.

In Prepaid Tuition Plans, the account holder, in essence, purchases units or credits at participating colleges and universities which may be used by his/her beneficiary’s future tuition fees and other mandatory fees. Meanwhile, Education Savings Plans are investment accounts that cover the beneficiary’s qualified higher education expenses which may include not only tuition and mandatory fees, but also room and board and textbooks.

Let’s go over the tax benefits under 529 plans in detail.

Tax-Deferred Growth

Your earnings in the plan grow federal tax-free. This rakes in a huge amount of savings on income tax as opposed to other investment vehicles where earnings are taxable and withdrawals are subject to capital gains tax.

State Tax Deduction or Credit

Although 529 plan contributions are not deductible on federal income tax, some states offer a tax deduction or credit if you contribute to your home state’s 529 programs. There are also states which offer income tax benefits regardless of where you invest:

• Arizona
• Arkansas
• Kansas
• Minnesota
• Missouri
• Montana
• Pennsylvania

Tax-Free Distributions

Distributions from the plan are not taxable, provided that they are used for qualified education expenses. Otherwise, distributions are subject to tax and a 10% penalty.

Furthermore, there are no income tax consequences for qualified rollovers and changes of designated beneficiaries.

Rollovers

The distribution of any amount from a qualified tuition plan (QTP) is not taxable if it is rolled over to:

• Another QTP for the benefit of the same beneficiary or of a member of the beneficiary’s family;
• A 529 ABLE Account for the benefit of the same beneficiary or of a member of the beneficiary’s family.

Change of Designated Beneficiary

Changing a designated beneficiary is also non-taxable as long as the new beneficiary is a member of the family of the previously designated beneficiary.

For purposes of rollovers and change of designated beneficiary, a member of the beneficiary’s family as provided by the Internal Revenue Service refers to any of the following:

1. Spouse;
2. Son, daughter, stepchild, foster child, adopted child, or a descendant of any of them;
3. Brother, sister, stepbrother, or stepsister;
4. Father or mother or ancestor of either;
5. Stepfather or stepmother;
6. Son or daughter of a brother or sister;
7. Brother or sister of father or mother;
8. Son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, or sister-in-law.
9. The spouse of any individual listed from items 2 to 8;
10. First cousin.

Estate Tax Exemption

Putting money in a 529 account can reduce or help you avoid federal estate tax because funds in such an account are exempt from federal estate tax.

Gift Tax Exclusion and Accelerated Gifting

Meanwhile, while contributions to 529 plans are considered gifts for tax purposes, the law grants you with a gift tax exclusion of up to $15,000 ($30,000 for married couple) per beneficiary per year. You can also opt for accelerated gifting using five-year gift tax averaging, which means that you can make a lump-sum contribution of $75,000 ($150,000 for married couple) which is five times the annual gift tax exclusion. This contribution will be treated as though it were spread over five years, making it still eligible for gift tax exclusion.

The Bottom Line: Save Early.

The earlier you invest in 529 plans, the earlier you can reap the benefits and the larger your savings will be on tax liabilities. Contact us now and we will help you save for college and maximize the tax benefits of 529 plans.