Tax reform added some new taxpayer-advantageous changes to college savings plans. These plans are also known as qualified tuition programs (QTPs) or Sec. 529 plans, named after the part of the Internal Revenue Code that established them.
Background: Sec. 529 plans allow taxpayers to put away larger amounts of money than other tax-advantaged education savings plans do, limited only by the contributor’s gift tax concerns and the contribution limits of the intended plan. There are no limits on the number of contributors, and there are no income or age limitations. The maximum amount that can be contributed per beneficiary (the intended student) is based on the projected cost of college education and will vary between the states’ plans. Some states base their maximum on the projected costs of an in-state four-year education, but others use the cost of the most expensive schools in the U.S., including graduate studies. Most have limits in excess of $200,000, with some topping $370,000. Generally, additional contributions cannot be made once an account reaches the state’s maximum level, but that doesn’t prevent the account from continuing to grow.
Although the plans are authorized by the various states, it is not necessary for the plan to be set up in the future student’s home state, and the student isn’t restricted to using the funds to attend college in their home state or the state where the plan was set up. Some states provide state income tax incentives to the plan’s contributors, such as a state income tax deduction or a tax credit for contributions to the state’s 529 plan.
When the time comes for college, the distributions will be part earnings/growth in value and part contributions. The contribution part is never taxable, and the earnings part is tax-free if used to pay for qualified college expenses. In addition to a tax-free distribution from the 529 plan, a taxpayer may claim an education credit – such as the American Opportunity Tax credit, which can be as much as $2,500 – in the same year, provided the same expenses aren’t used for both benefits and the taxpayer’s income level does not phase out the credit.
The big advantage of a Sec. 529 plan is tax-free accumulation, so the sooner the account is established and funded, the better. A special provision of Sec. 529 allows those who are concerned with the annual gift tax limitations, currently $15,000, to contribute five years’ worth of contributions ($75,000) up front. These limitations apply to each contributor, but if there are multiple contributors, such as parents, grandparents, aunts and uncles, huge amounts can be contributed up front and provide the greatest long-term growth.
Tax Reform Changes: Under the recent tax reform, the use of Sec. 529 plan funds was expanded to include:
Elementary and Secondary School Tuition – As of 2018, tax-free distributions of up to $10,000 per year per designated beneficiary are allowed for tuition (no other expenses are allowed) in connection with enrollment or attendance at elementary or secondary schools, including public, private and religious schools. However, this option should be considered cautiously, since Sec. 529 plans work best when the money put into the plan is allowed to grow for a long period of time. For less well-to-do families who can’t afford to frontload their 529 plan contributions, making pre-college withdrawals will defeat the long-term tax-free accumulation benefit and could deplete the account before the student even starts college. It should be noted that while this tax reform change applies for federal purposes, some states are still limiting qualified distributions from their plans to only those used for college expenses.
Sec 529 to ABLE Account Transfers – Tax reform also provides that a distribution from a Sec. 529 qualified tuition plan account is tax-free and penalty-free if it is rolled over within 60 days to an ABLE account of the same designated beneficiary or a member of the designated beneficiary’s family. This rollover provision is only available through 2025. The amount of the rollover is limited, when combined with other contributions, to the annual maximum.
Qualified ABLE programs provide the means for individuals and families to contribute and save for the purpose of supporting individuals who became blind or severely disabled before turning age 26, in maintaining their health, independence, and quality of life.
Example: Bill, who finished school and graduated, still has $8,000 in his Sec. 529 qualified tuition plan that his parents had set up to pay his college tuition. Bill will no longer have any education expenses, so he rolls the balance of his Sec. 529 plan into his 14-year-old blind niece’s ABLE account within the 60 days allowed. There are no taxes or penalties on the rollover. However, since contributions to the ABLE account are limited to $15,000 (2018), others may only contribute an additional $7,000 ($15,000 − $8,000) to the niece’s ABLE account.
Have questions on Sec. 529 Plans? Contact Charles Woodson.