529 Higher Education Savings Plans
Are tax-advantaged savings programs to pay for a student’s qualified higher education expenses. Cash contributions are made to an account established for a named beneficiary. Typically, investment management firms manage the funds in the account. The amount that becomes available to pay for the beneficiary’s education depends on the growth occurring between the contribution and the withdrawal. These accounts are not insured and losses may be possible.
Under federal law, contributions are not tax deductible and any growth in the account is tax-deferred. Distributions used to pay for qualified higher education expenses are not taxed. State or local laws can vary widely and contributions may or may not be tax deductible, and distributions may or may not be tax exempt.
Contributions must be in cash and may not be more than the amount necessary for a beneficiary’s qualified higher education expenses. Program sponsors specify the maximum contribution allowed. Many programs allow contributions of more than $250,000 for a single beneficiary. Some donors may want to contribute lump-sum amounts, but many 529 savings plans can be set up with automatic monthly payments. Other things to consider:
• Contributions are considered completed gifts of a present interest for federal gift tax purpose. In general, federal gift tax won’t need to be paid if a contribution is limited to the annual gift tax exclusion amount. In 2009, $13,000 is that amount. Married couples can split gifts to make $26,000 annual total contribution.
• If the contribution for one beneficiary in one calendar year is higher than the annual gift tax exclusion amount, then the donor can treat the contribution as if it had been made over a five-year period. That means that in 2009, in one calendar year, an individual can contribute up to $65,000. A married couple can also split gifts so that $130,000 could be contributed.
• Contributions may be made to both Coverdell Education Savings Accounts (Coverdell ESA) and to prepaid plans in the same year for the same beneficiary.
Generally, distributions used to pay for qualified higher-education expenses are tax free and excluded from income if they are less than the qualified education expenses. If the distribution from a prepaid plan exceeds the qualified expenses, then the distributed earnings will be considered taxable income and a 10% tax may be added.
• The earnings portion of a distribution due to death or disability of the beneficiary or if the beneficiary receives certain scholarships is taxable as ordinary income.
• Distribution beneficiaries can be changed if the new beneficiary is a member of the original beneficiary’s family—generally, siblings, children, grandchildren, parents, grandparents, nieces or nephews, uncles or aunts, their spouses and first cousins. If a beneficiary is not a member of the same family as the original beneficiary or if the rollover isn’t complete 60 days, then the earnings portion of the distribution is subject to current income tax. Funds may be rolled from a 529 higher education savings plan to a 529 prepaid tuition plan and vice versa.
• If distributions from a savings plan are made for any other reason, the earnings portion is included in the taxable income of the recipient and a 10% tax penalty may apply.
• Regarding income tax treatment of contributions and withdrawals, state and local laws can vary significantly from federal law.
• As long as the qualifying educational expenses are not identical, then a beneficiary may also claim, the American Opportunity Tax Credit or Lifetime Learning Credit, but both not in the same year. In addition, beneficiaries may receive a Coverdell ESA distribution or claim the tuition and fees deduction.
Other factors donors should understand:
• The beneficiary must be named at the time the account is created. Others, such as grandparents, along with the account owner, may contribute to the account.
• Currently, if the beneficiary is changed by the owner and the new beneficiary is in the same family, no tax liability will occur.
• The amounts in savings plans operated in one state generally may be used at an educational institution in a different state.
• A higher education savings plans involve investment risk, including loss. Prepaid plans do not guarantee that a beneficiary will be admitted to college nor does it mean that the college funding goal will be met in its entirety.
• According to federal law, neither the beneficiary nor the account owner is allowed to direct the account’s investments. Account owners may choose among the program sponsor’s available investment strategies. Changes in strategies are generally permitted once a calendar year, or when a new beneficiary is named. In calendar year 2009, account owners may change their investment strategy twice or upon a beneficiary change.
• Funds in most saving plans become the property of the beneficiary when he or she reaches the age of majority, or the age specified in state law. Custodial accounts are set up under the Uniform Gifts to Minors Act, the Uniform Transfers to Minors Act, or the local state version.
• Prepaid plans vary widely from state to state. Consider whether the plan in your or your beneficiary’s home state offers tax or other benefits unique to that state.
• If the prepaid plan is owned by the parent of a dependent student or an independent student, the assets are considered in the “Expected Family Contribution” calculations. In the financial aid determination process, the tax-free distributions from the 529 higher education savings plans are not counted as income to either the parent or the student.