Earnings in a 529 plan grow tax-deferred and are free of federal income tax when used for qualified higher education expenses under Internal Revenue Code Section 529 (26 U.S.C. 529). Qualified higher education expenses include tuition, mandatory fees, books, supplies, and equipment required for enrollment or attendance. Room and board expenses are also eligible for students enrolled half-time or more based on the current allowance for room and board determined by the eligible educational institution for federal financial aid purposes, or actual invoice amount charged by the institution to the beneficiary, if greater. In addition, qualified higher education expenses also include expenses of a special needs beneficiary that are necessary in connection with his or her enrollment or attendance at an eligible educational institution.
Earnings on non-qualified withdrawals may be subject to federal income tax and a 10% federal penalty tax, as well as state and local income taxes. Additionally, most states allow tax-deferred earnings and tax-free withdrawals for qualified higher education expenses, and some states allow families to deduct the full or a partial amount of their contribution from their state income taxes.
Even with decades in which to save for tuition, housing, and other college expenses, it can be difficult to ensure that your child has the funds they need to finish their degree with minimal debt, but the tax benefits offered by 529 plans can go a long way toward making this goal more attainable – and affordable. In fact, the tax benefit of a 529 plan is one of its most important traits, so let’s take a closer look at how these accounts are treated under state and federal tax codes.
Income Tax
Regardless of the source, most Americans have to pay income taxes on whatever money they earn over the course of the year, including those generated passively through investments. If you buy stocks or bonds, for instance, the money you end up making will be subject to capital gains taxes – unless those investments were made through a 529 plan. That’s because of the chief benefit of 529 plans: that earnings are not taxed by the federal government, as long as they are spent through qualified distributions.
In practice, an account owner with a 529 plan can spend those funds on elementary or secondary schools (up to $10,000 per year per person), apprenticeship costs, or even student loans (up to a $10,000 lifetime limit per person), all without incurring income tax when the money is earned or spent. On top of this federal tax break, many states offer their own tax credits or deductions, typically for those who use a plan in the state where they reside; check the benefits offered by your particular state when shopping around for a 529 plan.
Gift Tax
Most of the time, gifts to other people – defined by any contribution that does not elicit an equally valuable return – are limited through a federal gift tax, the threshold of which changes yearly to account for inflation. In 2020, for example, the most you can give to someone without incurring a tax is $15,000, and under U.S. tax laws, any contribution to a 529 plan is considered a gift. However, there is a unique tax provision governing donations to a 529 plan that makes it advantageous to contribute a large sum all at once.
Under this provision, someone looking to contribute to a 529 plan can treat a contribution as though it was made over the course of five years, rather than all at once; in other words, a donation of $75,000 to a 529 plan will not trigger the gift tax, since it can be treated as five separate $15,000 contributions, which falls within the limit. Because the investments made through these plans provide compounding returns, a large upfront deposit can generate much greater earnings over time, and thanks to the gift tax allowance for 529 plans, a sizeable donation can be made tax-free.
Estate Tax
For families with significant wealth, the US estate tax can represent a significant financial threat, so it’s worth noting the benefits of 529 plans for those who have to worry about this issue. Though there is still the gift tax to consider when making contributions of more than $15,000 per year, anyone looking to avoid the estate tax may want to place some of their assets in a 529 account because it removes those funds from their estate without forcing them to surrender control.
These accounts can be revoked or emptied at any time, so the money is still available if needed; keep in mind, however, as mentioned earlier, a 10% penalty and income tax on earnings if the funds are put toward non-qualified expenses, and money placed into a 529 plan may still factor into estate tax calculations if the contribution was made within five years of the estate owner’s death.