Before 1996, families faced limited options in saving for college. This changed with the Small Business Job Protection Act, which included a provision that led to the formation of Section 529 college accounts.

A 529 savings plan is an education investment vehicle that offers families attractive tax benefits while maintaining control of the asset. Every state minus Wyoming has a state-sponsored plan, and 35 states provide state tax deductions. Plan funds can be used at most educational institutions, and families can use this tool to help determine if an institution is eligible.

Before we take a deeper dive, it should be noted that there are two types of 529 plans:

Prepaid tuition plan: Allows you to prepay tuition at today’s rates through a lump sum or installment payments. This option helps alleviate the concern of future tuition inflation. However, most plans cover tuition only and not expenses such as room and board and textbooks.
Savings plan: An investment account that allows you to save for future education expenses. Similar to a 401(k), 529 plans offer a wide range of stock-and-bond mutual fund investment options. Qualified expenses—including tuition, fees, textbooks, supplies, computers, and equipment—are generally considered tax-free withdrawals from a 529 savings plan.

While you are eligible to participate in both, the savings plan has more in assets versus the prepaid tuition plan. This post will focus on the savings plan and how recent reform has expanded its flexibility, along with a few of the most frequently asked questions.

Even though 529 plans offer attractive benefits, they have drawbacks and should be viewed as one of the many options at your disposal when addressing education planning.

Changes to 529 Plan Accounts

For nearly two decades, 529s were limited in that they could be used for only post-secondary education. This changed with the passage of several key reform measures.

The Tax Cuts and Jobs Act (TCJA) began allowing families in 2018 to use 529 plans to pay up to $10,000 per year, per beneficiary, of tuition expenses at elementary or secondary public, private, or religious schools.

Example: Tom and Jane have set up 529s for their two sons in high school. They can elect to withdraw up to $10,000/year per child ($20,000 total) to cover tuition-related expenses.

While 529s are considered gifts for tax purposes, annual contributions up to $15,000 (as of 2021) qualify for the annual gift tax exclusion. The TCJA allows individuals to front-load up to five years of contributions without any gift tax ramifications. Contributions over $15,000 require IRS Form 709 to be filed.

Example: Steve and Caroline can each lump-sum $75,000 into their grandchild’s 529 in 2021. They would be required to file IRS Form 709 for each of the five years. This strategy can come in handy for estate planning purposes.

Effective in 2019, the SECURE Act made it possible to use 529 funds to pay down student loans, up to a lifetime maximum of $10,000 per individual, which also extends to each of the beneficiary’s siblings. A 529 plan account owner may change the plan beneficiary at any time without tax consequences.

These reforms have given 529s the extra flexibility that many have long desired. The flexibility seems to be working, as total plan assets increased from ~$305 billion in 2018 to ~$375 billion in 2020.

Scholarships

A common question among parents is, “What happens to my 529 plan if my child receives a scholarship?” The good news is the education system does not punish smart or athletic children. Nonqualified withdrawals can be made penalty-free up to the scholarship amount, and you are only responsible for paying income tax on any earnings. The scholarship essentially turns the amount withdrawn from the 529 from a tax-free investment to a tax-deferred one.

It is important to note that most scholarships cover only tuition fees, which means 529 funds can be used to cover other expenses such as room and board, supplies, and textbooks.

Unused 529 Funds

The most common question is, “What happens if the funds aren’t used for any education-related expenses?” Generally speaking, nonqualified withdrawals are subject to federal income tax plus a 10% penalty on the earnings portion of the withdrawal. It should be noted that state income taxes can vary, and the principal portion of your withdrawal will never be taxed or subject to a penalty.

The good news is options are available that avoid taxes and penalties if a beneficiary does not go to college or if funds are left over.

The account can be transferred or “rolled over” to pay for qualified expenses of a different beneficiary. This includes the beneficiary’s siblings, parents, children, first cousins, nieces, and nephews.
As mentioned above, under the new tax laws, beneficiaries can use up to $10,000 to pay down their student loans or a family member’s student loans.

Exceptions to the Rule

In most instances, any nonqualified distributions are subject to tax and penalty. This is waived if the beneficiary:

Passes away
Becomes disabled
Attends a U.S. military academy
Uses the funds from the withdrawal to claim certain education credits
Receives a scholarship—as long as the withdrawal does not exceed the scholarship amount (see above)

Understanding the Intricacies of a 529 Account

Whether you are the beneficiary of a 529 account hoping to use it to maximize your educational experience or the person contributing for estate planning purposes, you have ways to make the most of a 529 plan.

Nobody wants to pay unnecessary taxes or needless penalties, but the withdrawal phase of using a 529 account can be confusing. It can also confuse the contributor who wants to avoid estate taxes and gift taxes while ensuring they leave a legacy.

Whatever side of the 529 plan you are on, seek financial advice—especially if an individual is a beneficiary of multiple 529 accounts with various owners, which requires a coordinated effort. Waiting until the last minute, when a child is ready to attend college, may lead to unnecessary and avoidable challenges.

Discuss your situation with a fee-only financial advisor.

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