Why a 529 Plan is the Right Choice to Save for your Child's Education

With the cost of higher education continuing to soar, planning for your child's future education has become more important than ever. One tool that can help ease the financial burden is a Qualified Tuition Program called a 529 plan. Not only do these plans offer a convenient way to save for education expenses, but they also come with significant tax benefits. In this post, I'll delve into the tax advantages of 529 plans and explore why they have become a popular choice for parents and students alike.

Tax-Free Earnings on Contributions

One of the most attractive features of 529 plans is their potential for tax-free earnings. There is no tax deduction when you contribute to a 529 plan, however the funds grow tax-free, meaning you don't have to pay federal taxes on any investment gains. This allows your savings to compound over time, maximizing the growth potential of your contributions. There are no set-dollar and income limitations or income phase-outs on the amount you can contribute each year but contributions cannot exceed the amount necessary to provide for education expenses for your child or beneficiary. Total contribution limits for 529 plans reach as high as $300,000, but these can vary state by state.

There is potential gift tax exposure for contributions to 529 plans that exceed the annual gift tax exclusion ($16,000 single, $32,000 Married Filing Jointly) which are indexed for inflation each year. In the event that you exceed the exclusion amount, you can elect to prorate those contributions over 5 years. For example, an individual can contribute up to $80,000 in a single year ($16,000 x 5) and not be subject to gift tax. If their spouse joins, contributions can be $160,000 for one child or beneficiary. This lump-sum contribution gets allocated to the individual's or couple's gift tax exclusion for the next five years. Additionally, as the exclusion increases with inflation, the amount of the increased exclusion may be given to the child's 529 plan and still be treated as part of the annual exclusion for that year. This strategy creates a tremendous opportunity for parents to sock away savings for their child sooner rather than later.

Distributions for Qualified Education Expenses

When it comes time to tap into the tax-free growth of your 529 plan, distributions must be made to pay for qualified education expenses. As a general rule, distributions from the plan that exceed the amount of qualified education expenses, are deemed taxable to the account holder. Qualified education expenses in the context of a Section 529 plan include tuition, fees, books, supplies, equipment, and certain room and board expenses for undergraduate or graduate education at an eligible educational institution. An eligible educational institution is any college, university, vocational school, or other postsecondary educational institution that is eligible to participate in a student aid program administered by the United States Department of Education.

One caveat here is that the student can be enrolled full-time, half-time, or less than half-time, but room and board expenses are only qualified expenses if the student is enrolled at least half of the full academic workload deemed by the school. Account owners should be mindful of the school's allowance for room and board expenses, as these expenses are qualified to the extent of the allowance set by the institution. Qualified education expenses should be reduced by any scholarships or grants the student obtains while attending an eligible education institution.

Rollover Flexibility:

529 plan operate much in the same way as other tax-deferred accounts in that distributions are not considered taxable unless they are rolled over within 60 days to another 529 plan for the same beneficiary or a member of the beneficiary's family. Only one rollover is allowed every 12 months. For rollover purposes, a beneficiary’s family includes the beneficiary’s spouse and the following other relatives of the beneficiary:

• Child or descendant of a child

• Brother, sister, stepbrother, or stepsister

• Father or mother or ancestor of either

• Stepfather or stepmother

• Son or daughter of a brother or sister

• Brother or sister of father or mother

• Son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, or sister-in-law

• The spouse of any individual listed previously

• First cousin

Changes in beneficiaries are not subject to gift or GST tax if the beneficiary is of the same generation or higher as the old beneficiary. However changes in beneficiaries to lower generations are subject to these taxes and will lower your lifetime gift tax exclusion amount.

Interplay with Education Tax Credits

The American Opportunity or Lifetime Learning Credit (but not both) can be claimed in the same year a beneficiary receives a tax-free distribution from a 529 plan, as long as the same education expenses are not taken into account for purposes of both benefits. In other words, you can't take these credits for the expenses you elected to include under your 529 plan distribution.

Additional Planning Considerations

529 plans can be held indefinitely by the account holder, as opposed to a Coverdell savings account, which requires distributions within 30 days after the beneficiary turns age 30. Additionally, 529 plans are not included under the gross estate of the account owner (except in the event of premature death of the beneficiary), meaning there's no need to move money out of the account to get under the estate tax exclusion. Interest on student loans are still deductible in conjunction with 529 plan distributions. The maximum deduction is $2500 per year with income phase-outs starting at $70,000 for single taxpayers, and $140,000 for joint returns. Up to $10,000 can be used to repay student loans from a 529 plan, and another $10,000 can be used to repay student loans of the beneficiary's siblings.

Conclusion

Saving for education is a vital long-term financial goal, and 529 plans provide an exceptional vehicle to achieve it. The tax benefits associated with these plans, including tax-free earnings, interplay with education credits, gift and estate tax advantages, and flexibility in changing beneficiaries, make them an attractive choice for parents and grandparents alike. By taking advantage of these tax benefits, you can effectively maximize your savings and help secure a brighter future for your loved ones. Start exploring your options and consult with a CPA and/or financial advisor to determine how a 529 plan can fit into your overall education savings strategy. For any questions regarding specific tax or financial planning advice, feel free to contact me, or book an appointment for a complimentary consultation!