Article

Financial Wellness • Forbes

Understanding The Tax Benefits Of 529 Plans

By Jamie Hopkins | 5-min read

Strategies to fund college education costs are garnering a heightened level of interest in recent years as student loan debt begins to balloon and the rising costs of college education continue to spike. In fact, the increasing cost of a college education has significantly outpaced national inflation by an average of 3.4% per year since 2005. According to CollegeBoard, four years at a private nonprofit college, including tuition, fees, and room and board, costs roughly $175,000 and a public four-year in-state college, while less expensive, costs close to $80,000. Many Americans are turning to student loans to fund the cost of college education, placing a strain on their finances well beyond graduation.  However, you can plan ahead and ease the burden by utilizing the tax advantageous 529 College Savings Plan. While you have likely heard about 529 plans, you might not know all of the tax benefits of utilizing this type of plan to fund college education costs.

Using a 529 plan to fund college education costs provides a variety of state and federal tax benefits. Most states offer some form of state income tax deduction or credit for contributions made to a 529 plan.  While the state tax benefits of using a 529 plan vary from state to state, they are often enhanced or dependent on funding an in-state 529 plan.  However, a few states (i.e., Arizona, Kansas, Maine, Missouri, Montana, and Pennsylvania), referred to as tax-parity states, offer income tax benefits regardless of whether or not an in-state 529 plan was utilized.  For instance, in Pennsylvania taxpayers can deduct up to $14,000 of contributions to a Pennsylvania 529 plan per year, per beneficiary, from their Pennsylvania taxable income. With a current state income tax rate of 3.07%, a Pennsylvania resident could save roughly $430 per year in taxes by contributing $14,000 to a 529 plan. As such, the state income tax deduction can be a strong driver to use a 529 plan, as it can result in a decent amount of income tax savings. Additionally, some states have higher state income tax rates than Pennsylvania or use a tax credit, which could result in even greater tax savings.

While the state income tax deduction is a nice added benefit, it is not the greatest benefit of using a 529 plan to fund college education costs. The real power behind a 529 comes from the tax-deferred growth and tax-free withdrawals it can provide.  First, 529 plans can be invested in a wide range of investment options; some offer guaranteed returns while others are more like traditional mutual fund and stock market investments.  The earnings generated in a 529 plan are not subject to federal income taxes, allowing the investments to grow without being depleted annually by taxes. Additionally, when the money is used for qualified education expenses, the distributions from the 529 plan are not subject to federal or state income taxes. The withdrawals can qualify for the special tax treatment if the money is used for higher education expenses, including fees, tuition costs, books, some room and board expenses, and other required expenses. This allows you to take full advantage of any investment gains by putting them directly towards college education costs and not having them reduced by income taxes.

But what happens if you overfund your 529 plan? Do you lose the money or can you use it for something else besides college education expenses? If you are the owner of a 529 plan, you don’t lose the money if you don’t use it for qualified higher education expenses.  However, you will lose some of the preferential tax benefits.  While your contributions will qualify for the state income tax deductions at the time they are made, and the growth will be tax-deferred, the earnings portion of your withdrawals will not be tax-free. You might owe state income taxes if you claimed a deduction or credit for your original contribution. Non-qualified withdrawals will be subject to federal income tax at your ordinary income tax rate, and you will be assessed an additional 10% withdrawal penalty.

Non-qualified withdrawals are taxed on a pro rata basis which means a portion of your withdrawal will be treated as a return of your contribution and a portion of your withdrawal will be treated as earnings. Suppose you contributed $14,000 to the 529 plan and 5 years later the account had grown and was now worth $20,000. Next, you want to figure out what portion of the account is taxable if you take a non-qualifying withdrawal for something other than education expenses. In this case, 70% of the account is contributions and 30% is growth.  As such, if you took a withdrawal of $10,000, 70% ($7,000) of the withdrawal, in that case, would be a return of your contribution and 30% ($3,000) would be earnings. So, in this case, you would owe federal income taxes on $3,000 plus a 10% penalty that is added right on top of your federal income tax rate.  Let’s say your federal income tax rate was 28%, you would owe 38% taxes on the $3,000.  Remember, you would likely owe state income taxes on the $3,000, and perhaps state income taxes on the $7,000 of contributions if you originally took a state income tax deduction for the contributions.

Additionally, there are some more complicated tax issues that can arise with 529 plans.  For instance, contributions to a 529 plan count as a present interest taxable gift to the beneficiary of the account. However, you can offset this tax issue by applying the annual federal gift tax exclusion amount to the gift. This allows someone to be able to gift up to $14,000 to a 529 account of any beneficiary without incurring federal gift tax. Additionally, married spouses filing jointly can engage in gift splitting and fund the account with $28,000 a year per beneficiary. If someone is looking for an opportunity to contribute even more money to a 529 plan in a single year, there is a special rule that allows an individual or couple to gift up to five times the annual federal gift tax exclusion amount in one year and spread the gift evenly over five years for gift tax purposes.

Changing the beneficiary on a 529 plan can create some tricky tax challenges. While you can generally change a beneficiary to a new beneficiary who is a family member of the old beneficiary without any income or gift tax issues, if you change the beneficiary to someone unrelated to the original beneficiary, you could incur a penalty tax, ordinary income on the growth, and a taxable gift.  So be careful whenever changing the beneficiary of a 529 plan.

While state income tax deductions are often a welcome benefit, it is also important to realize that the income tax-deferred and tax-free benefits are most valuable when you have a long time horizon to invest and allow your contributions to grow. This means you should set up a 529 plan for your child or beneficiary as early as possible to take full advantage of the growth and tax opportunities. Funding a 529 plan just a few years before the college expenses are incurred provides much more limited tax savings than setting up an account 18 years earlier and allowing the account to generate a tremendous amount of tax-free growth. When choosing a 529 plan, make sure you look at the in-state tax benefits and weigh that against the possibility of better investment options and lower fees in other state 529 plans.

 

This article was written by Jamie Hopkins from Forbes and was legally licensed through the NewsCred publisher network. Please direct all licensing questions to legal@newscred.com.

The views of the author of this article do not necessarily represent the views of Gradifi. We make no claims, promises or guarantees about the accuracy, completeness, or adequacy of the information contained here. Readers should consult their own attorneys or other tax or financial advisors to understand the tax, financial and legal consequences of any strategies mentioned in this article.