Article Highlights:

• Who Can Contribute?

• How Much Can Each Individual Contribute?

• Makeup Contributions

• Maximum Plan Contributions

• Tax Free Accumulation

• Eligible Expenses (Qualified Distributions)

• Non-qualified Distributions

• Be Mindful

• Direct Payment of Tuition

• Coordination With Education Credits

A common question parents have is, “How might I save for a child’s post-secondary education in a tax-beneficial way?” The answer depends on how much the education is expected to cost and how much time is left until the child heads off to college or a university or enters an apprenticeship program. The tax code provides a tax-beneficial plan to save for college expenses referred to as a Sec 529 Plan (named after the section of the tax code that authorizes the plan). These plans are also referred to Qualified Tuition Plans and are sponsored and run by the 50 states and the District of Columbia. There are two types of 529 plans: education savings plans and prepaid tuition plans.

Who Can Contribute? There are no limits on the number of contributors, and there are no income or age limitations. Thus the parents, grandparents, rich uncles and aunts, and although not very likely, even the next-door neighbors, can contribute to the student’s Sec 529 Plan.  

How Much Can Each Individual Contribute? That depends upon each person’s financial situation and the gift tax. Gift tax is currently 40% of the amount gifted but there two exclusions:

      • A lifetime gift and estate tax exclusion, which is annually adjusted for inflation, and is $12.92 million for 2023 (up from 12.06 million for 2022), and

      • An annual gift tax exemption per gift recipient which is periodically inflation-adjusted and is $17,000 for 2023 (up from $16,000 in 2022). Meaning an individual can give $17,000 (or whatever the amount is for the year) to any                 number of individuals without incurring any gift tax. For example, grandpa can give $17,000 to each of his six grandchildren in 2023 gift-tax free.  

Most individuals will not use any of the $12.06 million ($12.92 million in 2023) lifetime gift tax exclusion, which then can be used to reduce the value of their estate subject to the 40% estate tax when they pass away. Plus the lifetime exclusion is subject to partisan politics and could be increased or reduced in the future. It was $5.46 million in 2017 before being increased by the Tax Cuts and Jobs Act for years 2018 through 2025.  

In most cases, contributors to a 529 Plan limit the amount they give to the Plan to the annual gift tax exclusion ($17,000 for 2023). However, the tax code allows an individual to contribute 5 years’ worth of 529 Plan contributions in one year. Thus for example, in 2023 an individual could contribute $85,000 (5 x $17,000) without any gift tax consequences, but if that individual makes any additional contributions (except for makeup amounts) within the subsequent four years, those additional contributions would eat into their lifetime gift and estate tax exclusion.

After the conclusion of the five-year period, the individual can resume making contributions either annually or with another 5 years’ worth. The advantage to making the 5-year contributions is larger upfront appreciation.      

Makeup Contributions – Because the annual gift exclusion amount is inflation-adjusted, anyone who exercised the 5-year option and the annual gift exclusion amount increased during that 5-year period can contribute an amount equal to the increase. The following is a hypothetical example: Lee contributed $75,000 (5 x $15,000) to his granddaughter Whitney’s Sec 529 plan in 2019 when the annual exclusion was $15,000. The exclusion continued to be $15,000 for 2020 and 2021. In 2022 it increased to $16,000 and to $17,000 in 2023. Lee can make a $1,000 catch-up contribution for 2020 when the exclusion increased to $16,000 and a $2,000 catch-up in 2023 when the exclusion increased to $17,000.          

Maximum Plan Contributions – Although there are no restrictions on how much an individual can contribute annually, other than the gift tax considerations, 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. According to Savings for College.com the 2022 amounts range from $235,000 to $550,000. 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 there is no Federal tax deduction for contributing to a 529 Plan, some states do allow a deduction. Go to maximum account contribution for details by state.  Go to State Income Tax Benefits for state income tax benefits.

Tax Free Accumulation: You should also be aware that an account can be established in any state program, not just the resident state program. So shop around for the program with the best performance, since the major benefit of the Sec 529 Plan is earnings accumulation which is tax free if used for qualified higher education expenses. Plus, the earlier contributions are made to a plan the longer the account has to grow and provide tax free funds for the student’s education.      

Where 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.  

Eligible Expenses (Qualified Distributions) – Distributions from a Sec 529 Plan consists of two amounts, the contributed amounts and the earnings on the amounts contributed to the plan. The original contributions are never taxable and the earnings are not taxable if they are used to pay qualified higher-education expenses of the account beneficiary. These are the eligible expenses:

      • Tuition,

      • Fees,

      • Books,

      • Supplies,

      • Equipment,

      • Computers or peripheral equipment, computer software, internet access and related services that will be used primarily by the beneficiary while the beneficiary is enrolled at an eligible educational institution,

      • Room and board if the beneficiary attends a qualified school at least half time, and

      • A special needs student’s expenses that are necessary to enable the student to enroll or attend an eligible educational institution.

Since originating these plans, Congress has continued to modify the purpose of the plans by allowing plan funds to be used for more than just college tuition. In addition to the forgoing expenses, Sec 529 funds can be used federally tax free for:  

      • Up to $10,000 annually, per student, for elementary school and high school tuition expenses to attend public, private, and religious schools.

      • Qualified higher education expenses associated with registered apprenticeship programs certified by the Secretary of Labor under Sec 1 of the National Apprenticeship Act.

      • Payment of education loans up to a maximum of $10,000 (reduced by the amount of distributions so treated for all prior taxable years) including those for siblings. In other words, $10,000 is a lifetime limit.

Non-qualified Distributions - When distributions exceed eligible expenses, the beneficiary of the Section 529 Plan would be required to include the nonqualified distributions in income. Keep in mind the original contributions to the plan are never taxable, only the earnings. The calculation of the taxable amount of the distribution can be complicated, especially if the beneficiary received a tax-free scholarship. In some cases, a 10% penalty also applies on the taxable distribution that is included in income.

Be Mindful – The tax benefit of these plans is amassing tax-deferred investment income, which then can be withdrawn tax-free to pay qualified education expenses. Using these funds too early will not achieve the desired goal of accumulating and compounding investment income. Thus, you should carefully consider whether to use the funds for elementary and secondary school education expenses or to wait and tap the account for post-secondary education, with the latter choice maximizing investment income.

Direct Payment of Tuition – Some potential contributors to a Sec 529 plan for family members may wish to pay for the tuition when it is actually incurred rather than saving for it in advance. The gift tax rules exclude from gift tax direct payments (payments made directly to a provider) for tuition or medical services. Thus, for example, a grandparent can make direct payments to a college for a grandchild’s tuition and those payments are not subject to gift tax. The grandparent could even contribute to the Sec 529 Plan and later make direct tuition payments if needed.  

Coordination With Education Credits - 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, the student or the taxpayer who claims the student as a dependent 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.

If you have question or need assistance with education planning, please give this office a call.