529 Plan

529 Plan

What is a 529 plan?

A 529 plan is a tax-efficient savings plan designed to help pay for education. Originally designed to pay for post-secondary education fees, it has been expanded to also cover kindergarten to grade 12 education under the Tax Reduction and Jobs Act. There are two main types, prepaid tuition plans and savings plans. Prepaid tuition plans allow the plan holder to pay the beneficiary’s tuition and fees in advance at the designated institutions. Savings plans are tax-efficient investment vehicles, similar to IRAs.

The rules governing the plans are set out in section 529 of the Internal Revenue Code. They are legally called “qualified education programs” and sometimes called “section 529 plans”.

Operation of plans 529

A 529 plan allows a person to grow their savings on behalf of a beneficiary, who can be a child or grandchild, a spouse or even yourself. This can be beneficial when considering the costs of higher education. According to the College Board, for the year 2020-2019, the average annual cost of tuition in the state plus room and board was $ 21,370 in a four-year public college or university and $ 48,510 in a four-year private college or university.

$ 1.46 trillion

The collective amount of American student debt in the fourth quarter of 2020, according to the Federal Reserve Bank of New York.

Since its inception under the Small Business Job Protection Act of 1996, the 529 plan has become much more popular than other education savings vehicles, such as education savings bonds and the education savings account. Coverdell. Total assets invested in 529 plans reached $ 328.9 billion in 2020, according to the College Savings Plan Network. In December 2020, Congress passed a tax bill that also authorizes 529 funds for private education from kindergarten to grade 12.

Source: Network of college savings plans

A 529 plan can be drawn up by any person, including unrelated persons, for a designated beneficiary. There is no limit to the number of 529 plans an individual can set up, but contributions cannot exceed the cost of education or the limit set by the state. Therefore, if a plan has more than one contributor, these contributors must inform each other of their contributions to ensure that they do not exceed the limits.

Plan assets belong to the plan holder, not the beneficiary (although it may be the same person). The beneficiary has no rights to the assets, which can be withdrawn by the holder for any reason at any time (although the holder will incur penalties if the funds are not used for qualified education expenses of beneficiary).

The holder can also change the beneficiary of a 529 plan that he has put in place. A plan can be transferred to a beneficiary’s family member, or excess funds can be transferred to a family member’s plan. None of these actions trigger a penalty or tax. Although the beneficiary does not control plan assets, these assets can to a large extent affect the beneficiary’s eligibility for financial assistance. Plan assets are generally not counted in the plan holder’s estate, so 529 plans provide tax benefits.

What is covered by a 529 plan?

A 529 plan is intended to pay for qualified higher education expenses. Eligible expenses vary by plan. Tuition and compulsory fees may still be covered by distributions. Eligible educational institutions include colleges, universities, vocational schools or other post-secondary educational institutions eligible to participate in a student assistance program administered by the Ministry of Education. This includes virtually all public, not-for-profit, and accredited (private, for-profit) post-secondary educational institutions. Now K-12 schools are also eligible.

A 529 plan doesn’t just cover tuition fees. According to the IRS, it covers eligible expenses, including “computer technology or equipment”. These include desktop computers, laptops, and any computer-controlled device (such as a printer).

Internet service is also covered. However, cell phones and cell phone plans are not considered to be educational expenses or any technological device primarily used for entertainment.

Aside from technology, meal plans, room and board, and most other education-related expenses can be covered. However, transportation to and from school, expenses related to optional activities such as sports and clubs and entertainment costs are not covered. In addition, a 529 plan cannot be used to pay student loans.

Types of plans 529

There are two main types of 529 plans: the college savings plan and the prepaid tuition plan.

Savings plans

Under a college savings plan, the amounts are contributed up to the dollar limit of the plan. The assets of a college savings plan can be used to cover eligible expenses in any eligible educational institution.

Savings plans, which are only offered by states, are similar to IRAs in that they are tax-efficient ways to invest money over the long term. Plan holders generally have the option of investing in a range of mutual funds. These funds can be targeted to the date on which the beneficiary should start his studies and try to reduce the exposure to risk as this date approaches. Since the investor bears the risks of the investments, the amount that may be available for eligible education expenses will be affected by the rate of return on the investments.

Some advisers recommend that clients allocate 100% of the plan to equity funds until the beneficiary is 12 years old. While this prepares you for potential losses, you also have the option of maximum gain. In addition, the student may be eligible for grants and scholarships that reduce the burden of the 529 plan. As the child approaches college, more and more assets should be transferred from funds based on actions towards fixed income vehicles to preserve capital.

If you think the cost of college will increase by about 4% a year – and that you will earn about 6% a year from your contributions – you must contribute about $ 308 a month from the birth of your child until the start of his academic career at a four-year state public university to cover 65% of the total cost. If you start later, you will have to contribute more to achieve this goal. (Use this calculator to determine your contribution rate.)

Prepaid tuition plans

Prepaid tuition plans are offered by states and higher education institutions. In a way, they are analogous to futures contracts because they allow the plan holder to pay in advance for one or more semesters at colleges or universities designated at current prices. This protects them from tuition inflation, which has always been much higher than broader measures of inflation.

As part of a prepaid tuition program, eligible expenses for a fixed period of time or a fixed number of credits are prepaid at an eligible educational institution. For example, a person can make advance payments for two future college semesters at today’s cost. Prepayment guarantees the beneficiary two semesters, whatever the cost in the future. This means that the program manager bears the risks of the investments. Contributions are limited to the amounts necessary to pay the beneficiary’s eligible education costs.

Prepaid plans differ in their specifics, but often have limitations that do not apply to savings plans, such as age limits and residency requirements. They often have tighter limits on the expenses they can cover. Textbooks or room and board may not be eligible. However, some prepaid plans are guaranteed by the States, while savings plans are subject to market risk.

Unlike college savings plan assets, which can be used to pay for eligible expenses at any eligible educational institution, the assets of a prepaid tuition program are generally used for the expenses of a predetermined educational institution or educational institution from a predetermined list. If the beneficiary decides to attend an educational institution that is not on the predetermined list, the current market value of the prepayments may not be sufficient to cover comparable tuition fees in the other educational institution. This means that the beneficiary may have to cover the difference from his pocket.

There is a non-state prepaid plan, called the Private College 529 Plan (formerly Independent 529 Plan), which allows holders to prepay the tuition fees of a consortium of private schools. One problem with this plan, as with state plans, is that the choice of schools is limited. If the beneficiary does not enter and attend one of the selected schools, the funds can be transferred to another plan, which causes him to lose most of his earnings. Alternatively, they can be transferred to a member of the beneficiary’s family or carried over into the beneficiary’s plans, which does not involve any penalty.

Tax treatment of a 529 plan

Income from a 529 plan is exempt from federal income tax, provided that the withdrawals are used for eligible education expenses. Distributions that are not used to pay eligible education costs are subject to 10% taxes and fees, except in circumstances such as death and disability.

Contributing to a 529 plan does not reduce your federal tax burden by reducing your taxable income. However, more than 30 states offer tax deductions or credits for contributions in a 529 plan. Additionally, 529 plans offer certain federal tax benefits for contributions.

For example, while a gift over $ 15,000 would generally trigger gift taxes, there is a special exception for 529 plans. A contribution of up to $ 75,000 per person can be treated as if it had been made over a period of five calendar years, thus avoiding the tax if no other gift was made to this child by the individual until five years have passed. A gift of this size, made early in the child’s life, could grow considerably before being used for college. Note that a married couple could give this child $ 75,000 each, for a total donation of $ 150,000, if the plan allows.

Insight Advisor

Jay Murray
Tuition Solutions, Lone Tree, CO

529 plans have very specific transferability rules, governed by the Federal Tax Code (article 529). The owner (usually you) can transfer to another 529 plan once a year, unless a change of beneficiary is involved. You do not have to change plans to change beneficiaries. You can transfer the plan to another family member, defined as:

  1. Son, daughter, stepson, foster child, adopted child or descendant of one of them.
  2. Brother, sister, half-brother or half-sister.
  3. Father or mother or ancestor of one or the other.
  4. Father-in-law or mother-in-law.
  5. Son or daughter of a brother or sister.
  6. Father or mother brother or sister.
  7. Step-son, step-daughter, step-father, step-mother, step-brother or sister-in-law.
  8. The spouse of any person mentioned above.
  9. Cousin.

Choosing the Right Type of Plan 529

The type of plan you choose – whether it’s a university savings plan or a prepaid tuition program – is usually determined by the features and benefits that you find attractive. For example, do you want the beneficiary to be free to choose an educational institution they like, or are you happy that the beneficiary attends an institution chosen from a predetermined list?

Additionally, you should consider the range of plans or programs available for each type of 529 plan. For example, if you decide that you prefer to set up a college savings plan, you need to compare the features and benefits offered by your state. of residence with those of plans offered by other states. Some features you will want to compare include investment choices, fees and other expenses, plan restrictions and / or limitations (such as change of beneficiary rules or investment choices), and whether the plan allows renewals from other savings program studies.

Whichever 529 plan you choose, the important thing is to make a choice and start early. For college education savings plans, starting early increases the cumulative effect of earnings on contributions. And for prepaid tuition programs, the cost of tuition is usually lower if prepayments are made earlier.

Options for withdrawing money from a 529 plan

As mentioned, withdrawals from a 529 plan are tax-exempt if the money is used for qualified higher education expenses at an eligible institution. When the time comes to start distributing money, three options are available:

1. Sending a check to the school

It may seem like sending funds directly to school would be the easiest option, but it could be problematic if the withdrawal supplements financial aid. The school may choose to adjust the amount of student financial assistance based on the amount of the 529 plan distribution. If the aid package is too small, you may need to withdraw additional funds from the plan or close the gap in your pocket. Carefully plan how you will maximize the student assistance options for your 529 beneficiary before sending money.

2. Send you a check

Sending the check to yourself can avoid this problem, but it requires you to make sure your student expenses are paid. You must also report the distribution on your tax return, requiring you to file Form 1099-Q. This could result in taxes and penalties on distribution, even when the funds have been used for eligible education expenses.

3. Sending a check to your beneficiary

This option poses the least hassle, allowing you to work around the problems of potential shrinking from a financial aid package or to cause a hiccup with your tax return. Assuming that the student is responsible for using the funds to pay for the study fees, the distribution would be considered tax-free and would not cause any snafus at tax time as long as your beneficiary files his own declaration.

If such a distribution becomes a taxable event, the gains would be taxed at the beneficiary’s tax rate, not the plan holder’s tax rate. Say, for example, that you have the plan, send your student a check for $ 20,000 to cover expenses for the next school year, after which he suddenly receives an unexpected scholarship of $ 5,000. The scholarship amount that is not used for education costs would be taxable income. However, the Internal Revenue Service would not address the additional 10% penalty that generally applies when an overdistribution is made from a 529 plan.

Although saving in a 529 plan offers many benefits to parents and students, it is important to have a strategy in place to withdraw from your account when the time comes. Paying the money directly to your beneficiary can reduce headaches, but you should check with your plan administrator to make sure it’s the best option. (For related reading, see “Can a 529 plan be applied to a student loan?”)

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