When thinking about college, a predominant thought is how to afford an education. One solution to discuss with your clients is the contribution of funds into a qualified tuition program, better known as a 529 plan. Generally, distributions and earnings from a 529 plan are not taxable when used to pay for certain qualified education expenses. However, it is important to understand the rules concerning qualified education expenses, as well as special rules regarding 529 plans, in order to minimize the tax consequences and maximize the benefits.
What is a 529 Plan?
A 529 plan is a savings plan maintained by states and qualifying agencies which allow a contributor either to prepay the beneficiary’s qualified higher education expenses or contribute to a plan for those expenses. There are no income restrictions on the contributors; however, the contributions cannot be more than necessary to provide qualified education expenses to the designated beneficiary. People can establish a 529 plan for themselves or for their spouse, children, grandchildren, nieces, or nephews. Furthermore, the 529 plan offers flexibility and allows a person in certain circumstances to change the beneficiary.
What Type of Expenses Can the 529 Be Used For?
A 529 plan can be used to pay “qualified higher education expenses,” which include payments for tuition, fees, room and board with exceptions, and other related expenses, including student activity fees, educational computer software, and books, for an eligible beneficiary enrolled at a qualified university or college.
Can It Used for Non-Higher Education Expenses?
Yes. Some of the often-overlooked expenses that are treated as “qualified higher education expenses” are as follows:
Elementary and secondary tuition. A 529 plan can help families pay for tuition for elementary and secondary public, private, or religious schools. However, distributions from a 529 plan cannot exceed $10,000 annually for the payment of elementary and secondary tuition per beneficiary.
Apprenticeship programs. Qualified higher education expenses also include certain expenses incurred for participation in registered and certified apprenticeship programs.
Special needs services. A 529 plan can be used to pay for certain special needs services in connection with the enrollment or attendance of a qualified educational program. If requirements are met, a 529 plan can be rolled over tax-free into an ABLE account of the designated beneficiary or a member of the family of the designated beneficiary. An ABLE account allows for additional tax-advantaged savings programs for individuals with disabilities without jeopardizing eligibility for public benefits.
Student loans. Over the lifetime of a student, a maximum of $10,000 from a 529 plan can be used toward the repayment of student loans. Additionally, a distribution can be used toward the repayment of a student loan of a sibling of the designated beneficiary. For example, if a 529 plan was established for Child A, the repayment of the student loan of Child A in the amount of $10,000 and the repayment of a student loan of Child A’s sibling in the amount of $10,000 would be considered a qualified higher educational expense as long as the repayment did not exceed the $10,000 lifetime cap as applied separately to Child A and Child A’s sibling. However, any interest paid on a student loan using a distribution from a 529 plan will not qualify for the student loan interest deduction.
What Are the Tax Implications of a 529 Plan?
Income tax implications. A 529 plan distribution consists of two parts: the return on capital (the initial contribution) and the return on investment (the earnings). The main tax benefits of a 529 Plan include the accumulation of earnings tax-free and distributions that are not taxable if the distribution is not greater than the qualified higher education expenses. However, if the distribution is greater than the qualified higher education expenses, the beneficiary will be subject to income tax on the portion of the distribution attributable to the earnings (the excess earnings).
The portion of a distribution attributable to the initial contribution will never be subject to income tax. Accordingly, for federal income tax purposes, if the distribution does not exceed the amount of qualified higher education expenses, the distribution will not be taxable. However, it is important to note that distributions for elementary and secondary expenses, as well as other expenses that are treated as qualified higher education expenses under the Internal Revenue Code, may not be exempt from certain state taxes.
Potential 10% penalty. Unless an exception applies, the excess earning will also be subject to a 10% penalty. Exceptions to this additional penalty apply when the beneficiary becomes disabled or upon death. There are also special rules that apply if the beneficiary attends a US military school or receives a scholarship or grant.
Refunded tuition. If a student receives a refund of tuition paid, the actual expenses may become less than the distribution withdrawn to fund the tuition expense for that academic period. As a result, the excess earnings would be reported as gross income. To avoid the distribution from being included in gross income, the student must recontribute the refunded amount within 60 days of the refund.
Gift tax implications. Annual contributions to a 529 plan that do not exceed the annual gift tax exclusion will not be subject to gift tax. However, if a contribution is made in excess of the annual gift tax exclusion, the taxpayer is allowed to make an election to treat the contribution as made over a five-year period. It is important to note that each spouse can make separate gifts to the beneficiary each year. Thus, with the annual gift tax exclusion in 2022 being $16,000, a married couple could contribution $32,000 to a 529 plan for a beneficiary and avoid the gift tax under the annual gift tax exclusion—assuming neither made an additional gift to the beneficiary in the taxable year.
Record-keeping. In case of an audit, it is recommended that a taxpayer obtain all records related to a 529 plan, including receipts of bills paid and account statements.
A 529 plan is just one tool for helping with the financial burden of education. Other vehicles for assistance include the American Opportunity and Lifetime Learning Credits and the Coverdell Education Savings Account. Accordingly, it is important that a client consult with a tax adviser when using a 529 plan and any other tax advantage savings plans or tax credits.
This article does not necessarily reflect the opinion of The Bureau of National Affairs, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.
Author Information
Kristin Balding Gutting is a principal at FORVIS, LLP where she leads the firm’s Tax Controversy and Procedure Group.
Caitlyn Meehan is a manager at FORVIS, LLP where she is in the firm’s Tax Controversy and Procedure Group.
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