Added to the tax code in 1996, Section 529 College Savings Plans (“529 plans”) have grown in popularity, leading to increased investment in them over time. Starting this year, 529 plans may become even more popular.
529 plans are commonly referred to as qualified tuition plans. Such plans are sponsored by various states and assist individuals with setting aside funds for future educational costs. 529 plans allow college savings to grow tax free, and, if withdrawn for the qualified education expenses of the beneficiary, no tax will be due on the earnings of the investments. Qualified expenses include tuition and fees, books and supplies, computers, and possibly, room and board.
Beginning in 2018, the Tax Cuts and Jobs Act (TCJA) expanded the definition of qualified expenses to include not just postsecondary school expenses but also up to $10,000 per year of tuition expenses for K-12 private or public schools. Moreover, this change is permanent.
Additional reasons 529 plans have grown in popularity are:
For federal income tax purposes, there is no limit on how much one can contribute to a 529 plan. However, each individual state-sponsored plan may have its own limits on how much an individual can contribute during a particular year or during the duration of the investment. For federal tax purposes, contributions to 529 plans are not deductible. However, for state purposes, an individual may be entitled to a deduction. For example; individuals are entitled to a deduction of up to $5,000 ($10,000 for individuals filing joint returns) per year on their New York State tax return for contributions made to the New York State sponsored 529 plan.
How 529 Plans Work
An individual owner sets up a 529 plan account by contributing cash to the plan. Each account can have only one beneficiary, but each individual can have multiple accounts. During the time the account is open, the owner can change the beneficiary. Additionally, in the event of the account owner’s death, a new account owner can be named. Each different state-sponsored plan offers various investment options for the owner. In most cases, the options include a mix of mutual funds. The income earned within the account will grow tax free, if used for qualified expenses, when withdrawn. If not used for qualified expenses, the earnings portion of the withdrawal will be subject to tax at ordinary income tax rates. There will also be a 10% federal penalty on the earnings, with limited exceptions. Additionally, if you were able to deduct your original contributions on your state income tax return, you will generally be subject to additional recapture income in the state.
Estate Planning Considerations
For estate tax purposes, all contributions (including all future earnings) are removed from the donor’s taxable estate even though the individual retains control over the funds. However, individuals who make the five-year election on a gift tax filing and dies within the five years of the gift, will have the unamortized gift included in their estates. This distinguishes 529 plans from most estate tax-saving strategies, which typically require individuals to relinquish control over the assets. A 529 plan shields assets from estate taxes, even though individuals retain the right (with some limitations) to control the timing of distributions, change beneficiaries, move assets from one plan to another, or get their money back— subject to income taxes and penalties.
529 plans offer an array of options that can yield long-term benefits for parents and grandparents, as well as their children. However, 529 plans may not be the best planning tool for ultra-wealthy individuals looking to pass wealth to their children during their lifetime.
To help you determine what options are most appropriate for your circumstances, please reach out to your Berdon advisor.
Berdon LLP, New York Accountants