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Over the years the U.S. Congress has given taxpayers a variety of tax-advantaged ways to save and pay for higher education. One particularly effective program is the qualified tuition plan, commonly referred to as a “529 plan.” Since Congress added the 529 plan to the law in 1996, most states have established at least one 529 plan.
What Is a 529 Plan?
A 529 plan is a tax-advantaged investment savings account for saving for higher education expenses run by a state or by any higher education institution. A person, or the “owner,” establishes an account with the state the owner selects, deposits cash in the account and designates a beneficiary of that account. Until the beneficiary reaches college age, the plan invests the money in the account, and its earnings and growth during that time are not subject to federal income tax. When the beneficiary reaches college age, the funds in the account are generally used to pay expenses of the beneficiary’s higher education at any college or university, not just one in the state that sponsors the plan. Amounts withdrawn for most educational expenses are not subject to income tax. Amounts not used for educational expenses are subject to income tax when the assets are withdrawn or when the account is closed.
How Do I Set Up a 529 Plan?
A parent or grandparent, or any other donor, may establish an account with a 529 plan simply by contributing cash to the plan and designating a beneficiary of the account. Most states permit nonresidents to set up accounts under their 529 plans.
How Much Can I Contribute?
Congress did not limit a person’s annual contributions to a 529 plan account. It did, however, require each state to set a total contribution limit based on the average cost of attending college, either public or private, in that state. Contribution limits on accounts in some states exceed $100,000.
A contribution to an account under a 529 plan is a gift to the designated beneficiary for gift tax purposes. Contributors are advised to consult with a tax or financial professional regarding limits and regulations concerning the gift tax.
How Are the Account Assets Invested?
The investment of 529 plan account assets often reflects an asset allocation based on the beneficiary’s age, emphasizing growth investments when the beneficiary is young and more conservative investments as the beneficiary reaches college age. Some plans permit the owner to select from more than one age-based asset allocation. Some plans also permit the owner to select one or more specific mutual funds in lieu of the age-based asset allocation model.
Are the Earnings Subject to Income Tax?
The earnings on assets held in a 529 plan are not subject to federal income tax. The earnings may also be exempt from state income tax, though often states limit that benefit to residents of the state who invest with the state’s plan.
Who Determines How the Account Funds Are Used?
Section 529 plans typically allow only the owner to withdraw assets from an account or to direct the plan to pay the assets on behalf of the beneficiary. As a result, the owner, rather than the beneficiary, controls how the funds in the account are used. The owner may use the account assets for the beneficiary’s tuition and fees, room and board, and books, supplies and equipment, including the purchase of a computer and related technologies for the student and the student’s parents if it is used for educational purposes. It is important to note that nothing in the law prohibits the use of account assets for purposes other than education, although doing so may give rise to income tax and a penalty.
Are Withdrawals from 529 Plans Subject to Income Tax?
Amounts withdrawn or distributed from a 529 plan account and used for qualified higher education expenses are not subject to federal income tax. Many states also defer state income tax for state residents, and several states even offer state income tax deductions for contributions to the account.
Any withdrawals not used for qualified higher education expenses are included in the owner’s taxable income and will be subject to income tax on the growth of the contribution plus a 10 percent penalty tax on withdrawals from 529 plan accounts not used for the beneficiary’s higher education expenses.
Can I Change the Beneficiary of a 529 Plan Account?
If the beneficiary chooses not to attend college or does not use all the assets in the account, the owner may transfer the account to another beneficiary without incurring federal income tax if the new beneficiary is a member of the previous beneficiary’s family. Family members for this purpose include children, grandchildren, siblings, stepchildren, stepsiblings, first cousins, parents, grandparents, stepparents, aunts and uncles, in-laws and spouses of those relatives. The transfer, however, will be a deemed gift by the beneficiary of the account if the new beneficiary is one or more generations below the original beneficiary (though the gift will qualify for the annual exclusion). Again, individuals are advised to consult a tax professional regarding the gift tax.
This article is compiled from information included in IRS Publication 970. Additional information from “On the Subject...” © Copyright 2001 McDermott, Will & Emery and is reprinted with permission.
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