It is the time of year to get ready to return to school. The return to school this year is looking very different for most students. Many students are adjusting to going to school virtually, living at home versus on campus, or a hybrid of online and in-person classes. With all the changes to how students attend school, there have been some changes to how 529 dollars can be used.
Before 2019 529 plan rules stated, distributions had to be used for qualified higher education expenses. 529 plan rules now include tuition expenses at an elementary or secondary public, private or religious school. For elementary and secondary distributions, there is a limit of $10,000 per tax year per student.
If you are considering starting a 529 plan to assist with tuition for a child, grandchild, niece, or nephew, you should consider a few things. There are two types of 529 plans: prepaid tuition plans and education savings plans.
The prepaid tuition plans let you purchase units or credits at participating colleges and universities for future tuition and required fees at current prices for a designated beneficiary (student). The federal government does not guarantee prepaid plans. Some state governments guarantee the money paid into these prepaid plans, and some do not. If the money contributed is not guaranteed, you need to understand that you could lose some or all the money if the plan’s sponsor has a financial shortfall. There is also the risk if the beneficiary (student) does not attend a participating college or university. The prepaid plan may pay less than if the beneficiary (student) attended a participating college or university.
Education savings plans are what most people know and use. Education savings plans let you open an investment account in which you are the owner and you name a beneficiary (student) to save for future qualified education expenses. Education savings plans can generally be used at any college or university, including some non-U.S. colleges and universities. To qualify for the tax free 529 distributions, the school must be federally accredited.
Many of these education savings plans allow for investments in mutual funds, exchange-traded funds, and age-based portfolios. Age-based portfolios automatically shift funds to be more conservative as the beneficiary (student) gets closer to college age. All education savings plans are sponsored by state governments but not guaranteed by the state governments, nor are they guaranteed by the federal government.
There are no income limits to who can open and contribute to a 529 plan. Any contributions to the plan are considered to be completed gift to the beneficiary (student). Contributions given over the annual gift exclusion can be elected to be treated as if contributed over 5 years. For example, you can contribute $75,000 into the plan in one year without any gift tax consequences provided no other gift is made to the account beneficiary during that year. Currently, the annual gift exclusion is $15,000 per year. $75,000 / 5 years is treated as $15,000 per year being contributed each year, avoiding the filing of a gift tax return. You cannot make additional gifts for the following 4 years since you made 5 years’ worth of contributions. Contributions into 529 plans are not deductible for federal tax purposes. Depending on the state rules, contributions may be deductible for state tax purposes.
Distributions of earnings out of 529 plans are excluded from income if used for qualified education expenses. Qualified expenses are tuitions, fees, books, supplies, equipment required for enrollment, or attending an eligible school. 529 distributions can also be used for reasonable room and board costs for those who are at least half-time students in a degree program. Expenses for special needs services connected with enrollment or attendance at an eligible school are also qualified expenses. If distributions of earnings exceed the qualified expenses, the earnings portion of the excess distribution becomes taxable and is included in the beneficiary’s income.
The excess earnings portion of the distribution is now subject to a 10% penalty. There are exceptions to this penalty. If the distribution is due to the beneficiary’s death or disability or the beneficiary attends a U.S. Military Academy, the 10% penalty does not apply. The penalty does not apply if the 529 distribution is included in income because the beneficiary received a tax-free scholarship, veteran’s education assistance, or employer-paid education assistance.
For example, Sarah incurred $8,700 of qualified education expenses. Sarah received a partial tuition scholarship (tax-free) of $4,200 and took a 529 distribution of $4,600 for a total of $8,800. To figure out Sarah’s taxable portion of the 529 distribution, qualified tuition expenses $8,700 are required to be reduced by the tax-free scholarship of $4,200. This leaves qualified expenses of $4,500. All distributions are reported on Form 1099-Q with the amount of earnings included in the distribution. Sarah’s earnings on the 1099-Q are $1,200. Qualified expenses of $4,500 divided by the 529 distribution of $4,600 multiplied by the earnings of $1,200 give Sarah $1,173.91 of tax-free earnings. Sarah has $26.09 of taxable earnings ($1,200 of earning minus $1,173.91 of tax-free earnings) to be reported on her tax return but not subject to the 10% penalty.
529 plans allow the owner to rollover money left in the account once the beneficiary has completed school to another beneficiary in the same family. Eligible family members include spouses, children, stepchildren, grandchildren, siblings, step-siblings, parents, grandparents, stepparents, nieces, nephews, aunts, uncles, in-laws, and first cousins. 529 money can be rolled over to spouses of any of these individuals except first cousins.
For taxpayers who can claim the education credit, it is important to remember the credit can be claimed in the same year the 529 distribution is made. The expenses claimed for the credit and 529 distribution cannot be the same. There is no double dipping. You may want to consult your tax preparer and your financial planner to help you figure out the best way to coordinate financial aid, 529 distributions and credits during college years.