All You Need to Know About 529 Plans

All You Need to Know About 529 Plans

If you don’t have the right plan for distributions, all of the advantages of a 529 Plan could end up costing you thousands.

Congress created 529 plans in 1996 and they are named after section 529 of the Internal Revenue code. They are plans operated by a state or educational institution, with tax advantages and potentially other incentives to make it easier to save for college and other post-secondary training for a designated beneficiary, such as a child or grandchild. Each state has its own, unique plan and they are allowed to offer both types of plans: prepaid tuition and savings plans. You are not restricted to your own state’s 529 plan. Your state may offer incentives to win your business, but the market is competitive and you may find another plan you like more. Be sure to compare the various features of different plans. You may have to “recapture” some of your deductions if funds were not used for secondary learning.

Each 529 Plan account has only one designated beneficiary, usually the student or future student for whom the plan is intended to provide benefits. The beneficiary is generally not limited to attending schools in the state that sponsors their 529 plan. But to be sure, check with a plan before setting up an account. Earnings are not subject to federal tax and generally not subject to state tax when used for the qualified education expenses of the designated beneficiary, such as tuition, fees, books, as well as room and board. Contributions to a 529 plan are not deductible on your Federal tax return; however, most states allow deductions if you use their plan (Michigan has the MESP that allows a deduction of up to $10,000 for married couple, $5,000 for single).

TAX TIP – There are Federal Estate and Gift Tax Benefits for contributions into a 529 plan. The contributions can lower the overall value of the estate as well as qualifying for the annual federal gift tax exclusion (remains at $14,000 per spouse per beneficiary). Taxpayers can gift up to 5 years at once ($140,000 for married couple) and still be excluded from gift taxes. The maximum amount you can contribute is $235,000 for each beneficiary. You can transfer beneficiaries so long as they are a relative of previous beneficiary.

Accounts can be opened by anyone who is a US Citizen and has reached the age of majority (18). The funds can be used for any secondary school and not just for higher learning institutions in your state. Withdrawals need to be disbursed in the TAX YEAR that the qualified higher education expense were paid. You generally have three options when requesting a distribution from a 529 plan: 1) a check made payable to the account owner, 2) a check made payable to the student or 3) a payment made directly from the 529 plan to the student’s college.

TAX TIP – Consider having the check made payable to the student. They will receive a 1099-Q tax form reporting the distribution to the IRS showing the student’s name and Social Security number. If the student incurs qualifying higher education expenses, or QHEE, during the calendar year that are equal to, or greater than, the gross distribution figure on Form 1099-Q, the distribution is tax-free. And when all 529 plan distributions in a year are tax-free, nothing is shown on the student’s Form 1040.

Another reason for preferring the second option concerns situations where the earnings portion of the distribution is fully or partially taxable because the beneficiary has insufficient qualified educational expenses. This can occur, for example, because the beneficiary received a scholarship and the account owner made a decision to pull unneeded funds from the 529 plan. It’s important to note that taxable distributions avoid the usual 10 percent penalty to the extent the beneficiary received scholarship monies.

TAX TIP – By making sure the distribution is reported to the beneficiary, the earnings are taxed at the student’s tax bracket, which is typically much lower than the account owner’s bracket unless the so-called “kiddie tax” applies. The kiddie tax requires certain children as old as 23 to pay tax on unearned income at their parents’ tax brackets.

Be careful of directing the 529 plan to make payment directly to the school. Those payments will be treated in much the same way that outside scholarships are treated. If the student is awarded a needs-based financial aid package, the school can adjust that award downward on a dollar-for-dollar basis. Be sure you ask about the policies at your child’s particular school beforehand.

Funds can be used for tuition, mandatory fees, books, supplies, and equipment required for enrollment or attendance, certain room and board costs, and expenses for “special needs” students.

A qualified, nontaxable distribution from a 529 plan includes the cost of the purchase of any computer technology, related equipment and/or related services such as Internet access. The technology, equipment or services qualify if they are used by the beneficiary of the plan and the beneficiary’s family during any of the years the beneficiary is enrolled at an eligible educational institution. This means any computer and related peripheral equipment. Related peripheral equipment is defined as any auxiliary machine (whether on-line or off-line) which is designed to be placed under the control of the central processing unit of a computer, such as a printer. This does not include equipment of a kind used primarily for amusement or entertainment. “Computer technology” also includes computer software used for educational purposes. Such costs are generally not qualifying expenses for the American opportunity credit, Hope credit, lifetime learning credit or the tuition and fees deduction.

TAX TIP – There are no income restrictions to contribute to a 529. There is no time limit for the assets to be in the 529 plan and no age requirements for withdrawal. Assets in a 529 plan are not used in calculating RMDs and you can always use your RMDs to deposit into 529 plans.

Taxation and Withdrawal Strategies

Only the earnings portion of a non-qualified withdrawal is subject to a 10% withdrawal penalty. Distributions are allocated on a pro-rate basis, which means that withdrawals will be divided into contributions and earnings based on the formula:

Account Contributions / Account Value X Distributions = Contribution Portion

Please note your contributions will never incur a penalty, and only the earnings portion is ever taxed.

There are a few exceptions to this 10% penalty on non-qualified withdrawals; if the beneficiary dies or becomes disabled; if the student attends a US Military Academy; or if the student receives a scholarship. All earnings on non-qualified distributions will be subject to tax as ordinary income at your tax rate. Withdrawal rates for most 529 account owners is 100% of qualified expenses MINUS $4,000 (American Opportunity Tax Credit – AOTC). If you don’t, you could be facing a 10% penalty plus adding $4,000 to your AGI. There is an income-phase out where the owners of the 529 cannot claim the AOTC so they would not have to adjust for it.

TAX TIP – End of year tax planning, owners of 529 plans should sit down and calculate exactly how much was spent on qualified expenses and make appropriate reimbursement distributions from the 529 plan. Maximize the AOTC by considering paying tuition bill in December rather January.

Most 529 plans allow you to take withdrawals yourself, send the withdrawal straight to the beneficiary or paid directly to the university. Whoever receives the check will receive the 1099-Q representing the distribution. It should not matter for as long as the qualified expenses supported the distribution but the funds received were too much then the distribution becomes a taxable event. One thing to consider, if the institution receives the check, it may treat it as some sort of scholarship, and could reduce the student’s financial aid package.

It is extremely important to have the right strategy going in so you can have the right results coming out. We can help you determine the right amount either in lump sum or over time to contribute, the right plan and the investment choices each plan brings and we will help you plan the right course of action for your distributions.

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Reduce Your College Costs by Great Tax Planning

Saving for your kid’s college can be harder than saving for your retirement. The clock starts ticking the day your child is born and as college draws closer, the less risk you can afford to take. Consider these tax-advantaged tools:
• Coverdell Education Savings Accounts (“ESAs”) let you save up to $2,000 per year per student. Earnings grow tax-deferred, and withdrawals are tax free for education costs.
• Section 529 Plans are state-sponsored college savings plans. Each state sets its own lifetime contribution limit, which ranges between $100,000 and $300,000+. Traditional “prepaid tuition” plans cover specific units of tuition such as a credit hour or course. Newer “college savings” plans invest contributions in mutual funds for potentially higher growth, generally adjusting portfolios from stocks to bonds and cash as your child ages. You can choose any state’s plan; however, some states offer deductions for contributions to their own plans.
• U.S. Savings Bonds let you defer tax on gains until you redeem the bond. Interest on Series EE Savings Bonds issued after 1989 to individuals age 24 or above may be tax-free if you use it the year you redeem the bond for “qualified educational costs” (tuition and fees minus tax-free scholarships, qualified state tuition plan benefits, and costs for which you claim the American Opportunity or Lifetime Learning credit). For 2015, the exclusion phases out for households with “modified AGI” from $77,200-92,200 (singles and heads of households) or $115,750-145,750 (joint filers) and isn’t available for married couples filing separately.
Plan Coverdell ESA Section 529 Plan
Donor AGI Limit $110,000 ($220,000 joint) None
Contribution Limit $2,000 per year $115,000-315,000 lifetime
(varies by state)
Federal Deduction None None
State Deduction None Some
Withdrawals Tax-free for elementary, secondary, and college costs, including reasonable room and board. Expenses paid out of ESA accounts do not qualify for American Opportunity or Lifetime Learning credits. Withdrawals not used for education are taxed as ordinary income. Tax-free for “qualified higher education expenses.” Withdrawals not used for college are taxable only if they exceed contributions.
Age Limit Use by age 30. Otherwise, pay tax on gains or roll into a family member’s ESA. Designate new beneficiary if child chooses not to attend college.

Section 529 plans offer estate-tax breaks in addition to income-tax breaks: Contributions are considered complete gifts for gift tax purposes; you can contribute up to $14,000 per year per student, or $28,000 jointly with your spouse, with no gift tax effect; 5 year accumulation plan states that you can give a beneficiary up to $80,000 in a single year, or $160,000 jointly with your spouse, so long as you give no more for the next four years; plan assets aren’t included in your taxable estate unless you “front-load” contributions in a single year then die before the end of that period.
What’s more is if you lose money in a 529 plan, you can close your account and deduct the loss as a miscellaneous itemized deduction. You can also transfer accounts from one plan to another, but only once a year. If you’re saving for college and you own permanent life insurance, you can deposit savings dollars into your policy and take tax-free cash for college (or anything else for that matter). If you later surrender the policy, any gains exceeding your total premiums are taxed as ordinary income when you surrender the policy (hint you can still get all of your money out while not surrendering the policy).

American Opportunity/Lifetime Learning Credits
These credits are available for parents (if they claim a student as a dependent) or students (if they can’t be claimed as someone else’s dependent). Here are the rules:
College Credits
Credit American Opportunity Lifetime Learning
Eligible Course You, your spouse, or your dependent enrolled at least half-time in the first four years of post-secondary education 1) Any year of postsecondary or graduate education
2) Any course of instruction at an eligible institution to acquire or improve job skills
Eligible Expenses 100% of the first $2,000 in expenses plus 25% of the next $2,000 in expenses; $2,500 maximum per student 20% of the first $10,000 in expenses; $2,000 annual maximum per taxpayer
• You can claim the full American Opportunity credit for as many students as qualify; however, the Lifetime Learning Credit is capped at $2,000 per taxpayer per year.
• The American Opportunity credit phases out as your AGI tops $80,000 ($160,000 for joint filers) (2015). The Lifetime Learning credit phases out as your AGI tops $55,000 ($110,000 joint) (2015).
• You can’t claim credits for expenses you pay out of an Education Savings Account or Section 529 Plan established for that student.
• Married couples filing separately can’t claim the credits.
Give Your Child Appreciated Assets to Pay College Costs
Previously it was possible to give appreciated assets to students age 18 or older before you sold them, to pay college costs. Your child’s tax on those gains would likely be less than yours. And this move kept down your AGI, which preserved your adjustments to income, deductions, and credits. You can give each child up to $14,000 per year ($28,000 per couple) with no gift tax consequence (2015). However, since 2008 the “kiddie tax” rules now apply to full-time students under age 24, thus greatly limiting this strategy.
You can withdraw funds from your IRA or qualified plan for college costs (tuition, room and board, books, and fees) without the usual 10% penalty for withdrawals before age 59½. Tax breaks for parents and students generally phase out as parental AGI rises, and financial aid is based on family income and assets. Emancipating your child severs that financial cord and lets your child qualify for tax breaks and financial aid according to their own income and assets. Your child will have to provide more than half of their own support (from investment and employment income) so that they no longer qualify as your dependent. This, in turn, lets them claim their own personal exemption (which may be phased out on your return anyway).
If dorm life doesn’t suit your scholar, consider buying them off-campus housing. As long as you can trust them not to trash the place, they’ll gain some real-world financial education and responsibility along with their college courses. This offers several tax and financial advantages:
• You can treat it as a second home and deduct mortgage interest and property taxes you pay on Schedule A. Or you can treat it as rental property, charge rent, and report rental income and expenses on Schedule E.
• You can pay your child a management fee and tax-advantaged employee benefits to manage the property.
• You can title the home in your child’s name (or jointly with them) and include them as a co-signer on the mortgage to help build their credit.
• A child who owns and occupies the home for two years can exclude up to $250,000 of gain from their income when they eventually sell.
Traditional tax planning seeks to minimize tax — period. But some tax strategies actually cost you when it comes time to apply for need-based college financial aid. So it’s important to know how your tax choices affect the Free Application for Federal Student Aid (“FAFSA”) that schools use to assess financial need.
All schools use a “federal methodology” to calculate how much federal aid they can disburse. Some schools also use an “institutional methodology” to calculate their own aid. Both methodologies work as follows:
The student’s “assessable income,” minus taxes and an “income protection allowance” times 50%
+ The student’s “assessable assets” times 20%
+ The parents’ “assessable income,” minus taxes and a living allowance times 22% to 47% (depending on income)
+ The parents’ “assessable assets,” minus an “asset protection allowance” (based on the older parent’s age) times 5.6%
= Expected family contribution (“EFC”)
“Cost of attendance” minus EFC equals “financial need.” The key, then, is to minimize assessable income and assets until after the last FAFSA reporting period. Here are key points to consider:
• Assessible assets generally include cash, checking and savings accounts, discretionary securities and investment accounts, and vacation home equity — but not qualified plan or retirement account balances, home equity, or personal assets. Some schools using the “institutional methodology” also include life insurance and annuity cash values, home equity, family farm equity, and siblings’ assets.
• Assessible income includes AGI (adjusted gross income) plus various “untaxed income and benefits” such as:
o earned income and child tax credits
o tax-free interest income
o child support received
o IRA and retirement plan contributions (be careful making contributions before your child enters college, as they are considered “up for grabs” to pay for school)
o untaxed gain on the sale of your primary residence
o gifts of cash (but not property) from friends and relatives (if grandparents or family want to make gifts, consider waiting to until after the student’s last FAFSA is due, or even making gifts after graduation to retire student loans)
o some schools using the “institutional methodology” also include flexible spending and health savings account contributions.
College costs are high enough that even families earning six-figure incomes can qualify for need-based aid. So don’t assume that your income automatically disqualifies you.
College financial aid decisions are based on the previous year’s income and assets — in most cases, with the “base year” starting January 1 of the child’s junior year in high school. This means it’s best to start planning no later than the start of your child’s junior year. FAFSA forms are due annually so long as the student seeks aid.
Assessable income does not include loan proceeds. This rule may make borrowing against life insurance, retirement or investment accounts, or your primary residence an appropriate source of tuition funds.

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