Qualified Tuition Programs (529 Plans)
Qualified tuition programs (QTPs) — also called 529 plans, after the section of the tax code that allows them, specifically IRC §529 — are programs set up by the state or by an eligible educational institution that allows taxpayers to contribute to either a fund that prepays qualified educational expenses or a savings account for a designated beneficiary, which can be the account owner. The designated beneficiary can be changed at any time. Earnings grow tax-deferred, but distributions that pay for qualified educational expenses are tax-free. Although 529 plans are better, Coverdell Education Savings Accounts can supplement 529 plans.
A 529 plan can be either a prepaid tuition plan or a savings plan. Prepaid tuition plans are of 2 types: one type is offered by either a public college or university within a state that allows the child to select any college or university within that state. Even if the child selects a private or an out-of-state school, the child can still receive the proceeds of the prepaid plan. The other type of plan is offered by a consortium of more than 270 private colleges and universities, which can be used to pay for expenses at any one of those colleges or universities. There is no restriction on the location of those institutions by state.
With the 529 savings plan, money is contributed to the savings plan and both the principal and any earnings may be used to pay for an education at a qualified institution. Furthermore, any savings plan offered by any state may be selected, regardless of the domicile of the taxpayer, and can be used to pay for expenses at any college or institution, regardless of its location. So a family living in Pennsylvania can select a plan offered by California to pay for an institution located in Florida. However, certain states offer tax savings if a resident chooses a plan offered by the state.
529 plans have these additional advantages:
- Rollovers are allowed once every 12 months.
- Funds may be rolled from one state's 529 plan to another state's plan or to a Coverdell ESA.
- Investment choices offered by the plan may be changed up to twice a year.
- No income limits for investors of a 529 plan.
- No deadline for using the 529 plan funds.
The Secure Act 2.0, passed at the end of 2022, makes it easier for employers to help workers open emergency savings accounts, assist employees who are repaying student loan debt and allow part-time workers access to retirement plans in 2 years instead of 3. There are also new benefits to both Roth IRAs and Roth 401(k)s, including moving leftover money from a 529 college savings account to a Roth I.R.A. Certain rules must be followed to avoid taxes and penalties, and there are some income restrictions. However, some provisions start in different tax years.
Secure Act 2.0 changes for 529 Plans, which take effect in 2024:
- Unused funds in a 529 college savings account may be rolled over to a Roth IRA.
- There is a $35,000 lifetime limit on these transfers per account beneficiary and other restrictions to lower the benefit for affluent taxpayers.
- The rollover must be a direct trustee to trustee transfer from the 529 plan to the Roth IRA.
- The 529 plan account must exist at least 15 years before transfers can be made.
- Contributions and earnings from those contributions from the previous 5 years cannot be transferred.
- Annual IRA contribution limits apply for the beneficiary, so the contributions by the beneficiary to a traditional IRA or a Roth IRA plus the amount rolled over cannot exceed the annual limits.
- However, the annual AGI limit for Roth IRA contributions does not apply to the transfer from the 529 plan to the Roth IRA.
Starting in 2018, under the new tax package passed by the Republicans at the end of 2017, known as the Tax Cuts and Jobs Act, 529 plans may be used to pay for K-12 private school tuition, which will help families who send their children to private school. Plan participants can distribute up to $10,000 each year per student for tuition at eligible institutions. 529 plans can also be rolled over into an ABLE account, if the account is owned by the 529 account beneficiary or by a member of their family. However, the amount rolled over will count towards the annual ABLE limitation, so any excess rollover will be included as taxable income for the recipient. However, the rollover may require the taxpayer to recapture a state deduction or any credit for amounts contributed to the 529 plan.
When choosing a plan, there are several criteria that should be considered:
- eligibility requirements
- enrollment fees
- account maintenance/management fees to track and handle accounts
- program maintenance fees to pay for the cost of running the 529 plan, ranging between 0.1% to 1.1% of assets, and
- fees charged by the funds held by the 529 plan, such as the fees charged by exchange-traded funds and mutual funds.
- A front-end sales charge, or load, may be charged when buying certain mutual funds.
- A deferred sales charge may also be assessed, charged only when money is withdrawn from the account, starting as high as 2.5%, then declining in successive years, until reaching zero, if the account is held long enough before withdrawing money.
- investment choices
- fund performance
- plan flexibility
- maximum contributions
- time limits on the plan
As with mutual funds, fees should be a topmost concern, since higher fees yield lower returns. Some 529 plans may offer breakpoints on their sales charge, like some mutual funds, that discounts fees commensurate with the amount invested. The greater the investment, the lower the fee as a percentage of assets. Several websites provide detailed information on plans offered by each state:
- Research and Compare 529 Plans - Shop, Compare and Enroll in Section 529 Plans - Includes eligibility requirements, maximum contributions, performance information, and contact information.
- Prepaid College Savings | 529 Private College Prepaid Plan | PC529 - Provides a list of colleges that provide prepaid plans.
Contributions to 529 Plans
Contributions must be cash, not property, such as stocks. Contribution limits, as set by each state, apply only to accounts within that state. However, there are no restrictions on having accounts in more than 1 state, greater contributions can be made with multiple accounts in multiple states.
Furthermore, contributions not exceeding the annual gift tax exclusion, which, in 2022 is $16,000, will not be subject to gift tax. Indeed, the tax code specifically allows contributors to give up to 5 times the annual gift tax exclusion as a lump sum, $80,000 in 2022, without incurring any gift tax liability. The contribution is treated as being spread over a 5-year period, which must be reported on Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return. If the lump-sum contribution is less than 5 times the gift tax annual exclusion, then the difference can be prorated over the 5-year term to allow additional gifts under the annual gift tax exclusion, what is called 5-year gift tax averaging. So if you contribute $50,000 to a 529 plan, then $5000 of that will be available in 2021 and at least $6000 will be available in 2022 and thereafter. Because each spouse can treat their gift as separate, a married couple can give up to $30,000 to each beneficiary each year and, starting in 2022, $32,000.
|2018 - 2021||$15,000|
|2013 - 2017||$14,000|
However, contributions to 529 plans are not tax-deductible. States may also set up QTPs that allow taxpayers to contribute to the fund that will eventually be used to pay the qualified educational expenses of a designated beneficiary. Distributions can also be combined with the American opportunity credit or the lifetime learning credit to finance the beneficiary's education. Information about particular QTPs can be obtained either from the state or from the educational institution.
Qualified educational expenses include those required for either enrollment or attendance in the form of tuition and fees, books, supplies, and equipment, and any special needs services that are required by a beneficiary with special needs. Room and board expenses also qualify for students enrolled at least half-time, meaning that the student is taking at least half the courses of what the educational institution considers to be a full-time workload. Distributions can also be used to pay for off-campus housing that is not part of the school as long as the expenses do not exceed the room and board allowance determined by the school. This allowance is used to determine the cost of attendance for federal financial aid. The school should be contacted to find out the amount of the allowance. Any distribution used to pay housing expenses that exceed the allowance is taxable.
The designated beneficiary is the person who will benefit from the QTP, but the designated beneficiary can be changed. There are no restrictions on the age of the beneficiary, so a taxpayer can set up a plan for herself to attend graduate school, for instance.
An eligible educational institution is any post secondary educational institution — such as a college, university, or vocational school, or K-12 private school — eligible to participate in the student aid program administered by the United States Department of Education. Starting in 2018, under the new tax package passed by the Republicans at the end of 2017, known as the Tax Cuts and Jobs Act, 529 plans may also be used to pay for K-12 private school tuition.
When being considered for financial aid, the total value of the 529 plan is assessed at the parental contribution rate of 5.64%, which is considered the student's expected family contribution. So 5.64% of the account value is used in determining eligibility for financial aid.
Unlike a Coverdell Education Savings Account (ESA), there is no contribution limit to the QTP, except that it cannot exceed the anticipated qualified educational expenses. Also, there are no income phaseout rules that apply to the contributors of the QTPs. Each donor to a QTP can also contribute to a Coverdell ESA for the same designated beneficiary in the same tax year.
Distributions from 529 Plans
The Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019 allows another type of qualified distribution:
- After the student graduates, if there is any money remaining in the plan, then up to $10,000 from 529 plans can be used to repay student loans. 529 funds can also be used to pay for certain apprenticeship programs. Both of these 529 changes apply to distributions after 2018.
Like a Coverdell ESA, QTP distributions consists of a return of capital, which was the amount contributed to the fund, and earnings. The portion of the distribution considered a return of capital is never taxable, but the portion of a distribution attributable to earnings is only tax-free if it is used to pay the adjusted qualified educational expenses of the beneficiary. That portion of earnings that does not pay for adjusted qualified educational expenses must be reported as income by the beneficiary. The beneficiary will receive a Form 1099-Q, Payments from Qualified Education Programs by the end of January in the following tax year from each QTP custodian that pays a distribution, showing the portion attributed to a return of capital and the portion attributed to earnings.
The 1st part in figuring a taxable distribution is to calculate the adjusted qualified education expenses (AQEE), which are the qualified educational expenses reduced by any tax-free educational assistance, including:
- scholarships and fellowships;
- Pell grants;
- veterans' educational assistance;
- employer-provided educational assistance; and
- any other nontaxable payments, except gifts or inheritances, which are never taxable to the recipient.
The 2nd part in the calculation requires that the earnings portion of the distribution, as shown on Form 1099-Q, be multiplied by the AQEE divided by the total distribution:
|Tax-Free Earnings||=||Earnings||×||Adjusted Qualified Education Expenses |
Taxable Earnings = Earnings − Tax-Free Earnings
|Total Qualified Education Expenses||$12,000|
|Gift from Parents||$1,600||Gifts and inheritance are always tax-free to the recipient.|
|Expenses Used to Calculate American Opportunity Credit||$4,000|
|Expenses Accounted for by the Tuition and Fees Deduction||$2,000|
|Adjusted Qualified Education Expenses (AQEE)||$2,900||=Total Qualified Education Expenses − Total Expenses Mitigated by Tax Benefits|
|Earnings, as Shown on Form 1099-Q||$950|
|Tax-Free Earnings||$520||= Earnings × AQEE/QTP Distribution|
|Taxable Earnings That Must Be Included As Income||$430||= Earnings − Tax-Free Earnings|
If the beneficiary receives both Coverdell distributions and QTP distributions, then the adjusted qualified education expenses must be allocated between the 2 distributions. Taxable earnings, if any, must then be calculated for each distribution:
|Allocation to ESA Distribution||=||AQEE||×||Coverdell ESA Distribution |
Taxable ESA Distribution = ESA Distribution − Tax-Free ESA Distribution
|Allocation to QTP Distribution||=||AQEE||×||QTP Distribution |
Taxable QTP Distribution = QTP Distribution − Tax-Free QTP Distribution
|Adjusted Qualified Education Expenses (AQEE)||$2,900|
|Coverdell ESA Distribution||$1,500|
|Allocation of ESA Distribution for AQEE||$725||= AQEE × ESA Distribution/Total Distribution|
|Allocation of QTP Distribution for AQEE||$2,175||= AQEE × QTP Distribution/Total Distribution|
Tips on Using 529 Funds
- As the time nears when 529 funds will be used for educational expenses, it is best to switch investments to money market funds, so that you are not forced to withdraw money during a stock or bond market decline.
- Under IRS rules, investments within a 529 account can only be switched twice per calendar year.
- Investments can also be switched if the beneficiary of the account is changed to another qualifying family member.
Using 529 funds:
- 529 funds can be used to pay room and board. Dorm expenses are always covered, but if your child lives off-campus than the amount considered qualified for off-campus housing is limited to the college’s cost-of-attendance figures.
- Some expenses, such as transportation and insurance, do not qualify as 529 expenses.
- Ask your plan provider if you are unsure about the qualification of some expenses.
- Although 529 funds can be used to pay for K-12 educational expenses, not every state recognizes elementary and secondary school expenses as qualified educational costs, so check your plan provider to be sure.
- Qualified expenses must be paid in the same calendar year, not the school year, when the money is withdrawn.
- Always document what expenses were paid with 529 funds.
Withdrawing money from a 529 account:
- Always use any available educational tax credits, the American Opportunity Tax Credit and the Lifetime Learning Credit, to pay for qualified expenses before using 529 funds.
- Any money left over can be used for another family member, including a spouse who would like to go back to school.
- Also, up to $10,000 can be used to repay student loans.
- 529 funds can also be used to pay for certain apprenticeship programs.
- If cash is withdrawn from the account without paying for qualified expenses, then you owe interest plus a 10% tax penalty on the earnings.
Losses on QTP Investments
Losses on QTP investments can be claimed by the beneficiary if the total of all distributions is less than the beneficiary's unrecovered basis, equal to the total amount of contributions to the account minus the total bases allocated to previous distributions.
Unrecovered Basis = Total Contributions − Bases Allocated to Previous Distributions
If the beneficiary has more than one QTP account, then all the QTP accounts must be netted out to determine if there's any remaining loss. Previous to the 2017 Tax Cuts and Jobs Act (TCJA), losses were deductible as a miscellaneous itemized deduction on Schedule A, Itemized Deductions subject to the 2% adjusted gross income (AGI) ) floor, so only that portion of a loss exceeding 2% of the beneficiary's AGI was deductible from gross income and only if the beneficiary claimed itemized deductionsns, but the TCJA eliminated this deduction. Therefore, QTP losses are no longer deductible.
Additional 10% Tax on Taxable Distributions
An additional 10% tax is assessed on any taxable earnings from distributions unless:
- the distribution was paid to a beneficiary or his estate after his death;
- the beneficiary is disabled;
- the taxable earnings arose because at least some of the expenses taken into account to calculate the adjusted qualified education expenses were used as a basis for calculating the American opportunity credit or the lifetime learning credit;
- earnings became taxable because the designated beneficiary received other tax benefits for some of the expenses, such as a tax-free scholarship or fellowship, but only to the extent that earnings do not exceed the tax-free assistance or payments; or
- the distribution was paid to a beneficiary attending a U.S. military academy, but only to the extent that the distribution does not exceed advanced educational costs.
Any rollover, where the distribution from 1 QTP account is rolled over to another QTP account within 60 days of the distribution, is not taxable if the account is for the same beneficiary or a close member of the beneficiary's family:
- children, stepchildren, foster children, adopted children, or any descendants thereof;
- siblings or step-siblings;
- any ancestors of the beneficiary;
- step-father or -mother;
- nephews, nieces, uncles, and aunts;
- children-in-law, parents-in-law, siblings-in-law;
- spouses of any of the above;
- first cousins.
However, if the rollover is between 2 accounts for the same beneficiary, then another same-beneficiary rollover cannot be made until at least 12 months have elapsed from a previous same-beneficiary rollover.
Rather than doing a rollover, a simpler method to transfer unused funds without tax consequences to another family member is to simply instruct the custodian of the QTP account to change the name of the beneficiary.