What are 529 Plans and What is The Best Way to Use Them (TUTORIAL)

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When you are looking to save for higher education expenses you can choose one of two routes the education savings account (ESA) or a 529 savings plan.

529 savings plans or “qualified tuition program”, were created under the Small Business Job Protection Act of 1996.

They were created as a means of allowing taxpayers to save for higher education expenses for a designated beneficiary.

A 529 plan may be provided by a state, an agency of the state or by an educational institution.

In this article we’ll look at what 529 savings plans are and how you use them to save for your child’s or grandchild’s college or university education.

What is a 529 Savings Plan?

The 529 plan is a method to save for expenses incurred with higher education. It is not unlike the education savings account (ESA).

In a 529 plan, the earnings accumulate on a tax-deferred basis. Distributions that are used for qualified education expenses are tax-and penalty-free.

The 529 plan differs from the ESA, in that it may allow individuals to prepay qualified higher-education expenses at eligible educational institutions.

Contribution limits for a 529 plan are considerably higher than those capped for an ESA.

Types of 529 Plans

529 plans come in two flavors.

Prepaid Tuition Programs

Prepaid Tuition Programs may be offered by the state of an eligible educational institution.

These allow for the advance purchase of credits for the designated beneficiary and are usually established during enrollment periods that are established by the state. I personally would opt against this since your limiting the choice of college to one school and are only garmented a rate of return similar to inflation.

College Savings Plans

College savings plans allow contributions to an account on behalf of the designated beneficiary.

These plans can usually be established at any time including immediately after a designated beneficiary’s birth

Individuals wishing to establish a 529 savings plan would review the feature and benefits of both types of 529 plans to determine which is more suitable for their needs.

Eligibility For a 529 Plan

Anyone can establish and contribute to a 529 plan on behalf of a designated beneficiary – family, friends etc. Even the designated beneficiary can establish the 529 plan for him- or herself.

Rules on 529 plans vary though.

Some 529 plans limit participation to residents of the state. Others allow anyone to participate, regardless of the individual's state of residence. In my case I utilized Utah’s plan for my daughter because at the time they offered lower fees and my home state of Massachusetts didn’t offer any state deductions for contributions. However, now that Massachusetts offers a deduction for the first $2,000 contributed for a married couple I have switched.

It’s a smart idea to check with the financial institution or the education institution providing the plan to determine the eligibility requirements.

In addition, some 529 plans may have established enrollment periods delimiting when a person can open a new account.

Age and Income Requirements On 529 Savings Plans

529 savings plans do not have income restrictions differing the ESA.

There are some 529 plans that do place age restrictions on designated beneficiaries. Always check with a plan provider and plan documents to determine whether there are any restrictions that apply to the 529 plan they want to establish.

Investment options available under the 529 plan may be determined by the age of the beneficiary. These are often adjusted automatically as the beneficiary's age changes predefined ranges.

On prepaid tuition programs, the cost per credit may be determined by the number of years that the designated beneficiary has left before attending college.

Contributions To 529 Plans

All regular contributions to 529 plans must be made in cash or checks

Contributions, such as stocks, bonds, mutual funds or other non-cash items cannot be used to make regular contributions.

Contribution Limit

The maximum amount that you may contribute varies from state to state.

Contributions are typically limited to amounts that are necessary to finance the beneficiary's eligible education expenses. Where limits are established, they usually occur on a lifetime basis.

As an example a plan may limit total contributions to $300k. This would then be the maximum total that can be contributed to 529 savings account over time.

Amounts contributed to a designated beneficiary's 529 account are treated as a gift. Contributions of up to $14,000 can be made without incurring federal gift tax.

An individual may be able to contribute a lump sum that covers five years, giving a total of $70,000 – $140,000 for married couples. This can be done provided the individual – or couple- makes no additional gifts for the five-year period.

Individuals must be careful about their contributions. The earnings portion of distributions that do not cover eligible expenses may be subject to income tax and early distribution penalties. Nevertheless, this is easy to get around. If there is left over money in the account all you need to do is change the beneficiary, say to your next child and let he or she use up the money.

529 Plan Tax Deduction Allowance

Some states allow taxpayers to receive a tax deduction for contributions, with certain requirements.

For instance a state's 529 savings plan may allow anyone (regardless of his or her state of residence) to participant in its 529 plan. The caveat being only residents of the state may qualify for a tax deduction for the contributions.

Investments Allowed in 529 Plans

529 plans are usually limited to mutual funds or annuities. The age of the beneficiary may influence investment choices. This allows for more aggressive investments for younger beneficiaries.

529 Plans: Distributions

Distributions from 529 plans used for qualified education expenses are tax- and penalty-free if the amount is equal to or less than the qualified expenses.

Distributions that are more than the qualified education expenses, may be subject to tax plus an additional 10% early-distribution penalty.
Some states may allow qualified individuals to claim tax deductions for contributions they make to 529 plans.  If you're allowed a tax deduction, state taxes may also apply to a distributions that are other than earnings.

529 Qualified Education Expenses

In general qualified education expenses include (but are not exclusive to)

  • Enrollment in and attendance at an eligible school (colleges, universities, vocational schools and accredited post-secondary educational institutions that are eligible for participation )
  • School tuition and fees
  • Books, supplies and equipment
  • Academic tutoring
  • School room and board
  • School uniforms
  • Transportation to and from the institution
  • Expenses of a special needs beneficiary necessary for enrollment and/or attendance

529 Plan Tax Treatment of Distributions

As mentioned previously, any distribution made from a 529 savings plan that is not used for qualified educational expenses may be subject to income tax and an additional 10% early-distribution penalty.

This penalty will be waived for any of the following reasons

  • The designated beneficiary dies and the distribution goes to another beneficiary or to the estate of the original beneficiary.
  • The designated beneficiary becomes disabled. This requires proof that he or she cannot do any substantial gainful activity because of a physical or mental condition.
  • The beneficiary of the 529 plan receives
    • A qualified scholarship excludable from gross income
    • Veterans' educational assistance
    • Employer-provided educational assistance
    • Other nontaxable payments –not gifts, bequests or inheritances – for education expenses

The penalty may also be waived if the distribution is included in income because the qualified education expenses were taken into account to determining the Hope Credit or Lifetime Learning Credit.

These are tax credits that reduce the amount of taxable income for an individual funding a student's education.

Rollovers, Transfers, Changing Designated Beneficiaries

The 529 plan allows the designated beneficiary to change to a qualified family member who meets any age requirements as determined by the plan.

A qualified family member includes the following:

  • The beneficiary's spouse
  • The beneficiary's son or daughter
  • A descendant of the beneficiary's son or daughter
  • The beneficiary's stepson or stepdaughter
  • A beneficiary's brother, sister, stepbrother or stepsister
  • The beneficiary's father or mother, or ancestor of either parent
  • A beneficiary's stepfather or stepmother
  • The beneficiary's niece or nephew
  • A beneficiary's aunt or uncle
  • The spouse of any individual listed above
  • Any individual for whom the home of the beneficiary is his or her primary home for the entire tax year
  • The designated beneficiary's first cousin

The rollover must happen within 60 days of distribution.

You can also make the rollover by changing the name and tax identification number on the 529 account to that of the new designated beneficiary.

Summary 529 Plans

The 529 plan is a smart way to save for education expenses that allows for the prepayment of qualified higher-education expenses at an eligible educational institution.

There are no income restrictions for individuals who want to contribute to a 529 plan and an individual may contribute up to $14,000 each year to a designated beneficiary's 529 plan without incurring federal gift tax.

Individuals should be aware of contribution limits. Contributions cannot be more than the amount necessary to provide for the qualified higher-education expenses of the beneficiary.

The earnings portion of distributions from contributions over the limit not used to cover such expenses may be subject to income tax and early distribution penalties.

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