By: Sheryl Parks, MSF, CFP®, CDFA®, Partner, Director of Financial Planning, Senior Financial Advisor
Most people know that a 529 plan is a tax-advantaged investment account that helps families save money for their children’s college education. Also known as qualified tuition plans, 529 plans are state sponsored, which means the rules can vary depending on where you live. But there is a lot more to 529 plans than meets the eye.
When I meet with clients, they are often surprised to learn how flexible a 529 plan is and how many opportunities it creates for tax-reducing strategies. Here are some lesser known facts about 529 plans that could help you increase savings and lower your tax liability.
Anyone Can Start a 529 Account
Most 529 accounts are opened by parents who name their children as beneficiaries, but legally, anyone can open a 529 account and name anyone as a beneficiary. Accounts can be opened by grandparents, aunts, uncles, neighbors, or friends. There is no limit to the number of 529 accounts that can be opened to benefit a single beneficiary.
529 Plans Can Be Used for More Than College Tuition
The list of qualified expenses has expanded so now funds in a 529 account can be applied for many types of schooling, not just to pay tuition at a four-year college. Qualified expenses include tuition and fees for elementary, secondary, vocational, and graduate school. (Note, there is an annual limit of $10,000 per year for qualified K-12 tuition expenses). Distribution from a 529 account can also go towards student loans, off-campus housing, food and meal plans, books and supplies, computers, etc.
529 Contributions Are Often Tax Deductible
One of the benefits of a 529 plan is that the growth is tax deferred, and withdrawals are tax-free so long as they're used for qualified expenses. In addition, 38 states offer either a state tax deduction or tax credits for contributions made to 529 accounts. The amount of the deduction varies by state and can change with the passage of new legislation, so it’s important to keep current. Unfortunately, there are no federal tax deductions for contributions to 529 accounts.
529 Plans Can Affect Financial Aid for College
The good news first – when your child is the beneficiary of a 529 plan owned by anyone other than a parent, there is no impact on your child’s financial aid award. For parents who own a 529 account, the dollar amount is considered an asset and will count against you in the FAFSA calculation. But the impact is minor, with a maximum of 5.64% of parental assets counted. If you have a $50,000 balance in your 529 account, you might see a reduction in the financial aid award of less than $3,000.
Tax Deductions When You Move to Another State
Because each state has their own 529 plan, when you move, you can roll over an existing plan into an account in your new home state. When you do, many states allow you to deduct the rollover amount from the taxes in your new state of residence. To be sure you get the maximum deduction, it’s important to understand the rules for your state. For instance, if you have $30,000 in a 529 account and the state allows a maximum deduction of $10,000, you can rollover $10,000 per year over a three year period to gain the biggest benefit.
Transferring 529 Account Between Beneficiaries
Most states allow 529 account owners to transfer all or part of the balances between 529 accounts with different beneficiaries. If the account for your oldest child has money left over after they’ve completed their education, you can transfer the remaining funds into a 529 account for a younger child.
529 Contributions Can Be Withdrawn without Big Tax Penalties
If you need to withdraw money from a 529 account for a nonqualifying expense, there is a 10% tax penalty, but it only applies to the interest earned, not the contributions. Let’s say you’ve contributed $40,000 to a 529 account that has earned $10,000 interest and now totals $50,000. If you needed to withdraw all $50,000, the 10% tax penalty would only apply to $10,000, the interest earned. You would end up paying a $1,000 penalty. However, any withdrawals would also be subject to income tax on the earnings.
Unspent 529 Plans Can Be Contributed to Roth IRAs
Thanks to passage of the Secure Act 2.0, starting in 2024, unused funds in a 529 plan can be rolled over into a Roth IRA with the following stipulations:
The 529 Plan has to have been established for 15 years.
Any contributions you made to the plan for the prior five years won’t qualify for the rollover.
You are limited to the typical Roth contribution of $6,500 per year.
The aggregate lifetime contribution limit is $35,000
While there are a lot of conditions, for some families this translates into a great opportunity to accumulate multi-generational wealth.
529 Plan Can Be Super-Funded
529 plans offer opportunities to grandparents looking for tax-savvy strategies to pass along wealth to family members. The annual gift exemption is the amount of money one person can transfer to someone else without paying a gift tax. Currently the maximum allowed is $17,000, so a grandparent can contribute $17,000– to a grandchild’s 529 account without tax ramifications. If they want to make a bigger gift while still avoiding tax ramifications, they can “super-fund” their contribution. In this scenario, the tax code allows them to contribute up to five years of the maximum gift exemption in a single year. With the current annual limit set at $17K, the grandparents could superfund a 529 plan with a one-time $85K contribution. This can only be done once every five years and the grandparents would need to fill out a gift tax return since they’re exceeding the annual gift tax exemption amount, but there are no tax liabilities.
Whenever the tax code comes into play, the devil is in the details. This is especially true with 529 plans where the rules change from state to state. If you have questions about 529 plans, contact our team at Marshall Financial Group. We’ll help you maximize your tax deductions and your contributions so you can get the most out of your 529 plan.