Co-authored by David Elyashar, CPA, CVA, Partner and Family Office Practice Leader at Wipfli LLP.
The following article was prepared in collaboration with our affiliate, Wipfli LLP. Wipfli ranks among the top accounting and business consulting firms in the nation.
529 plans are one of the most efficient ways you can grow your dollar in order to fund education for you and your family.
A 529 plan is a tax-advantaged savings plan where funds are used to pay for the qualified education expenses of the plan’s beneficiary. Qualified expenses include tuition, room and board, books, computers, special needs equipment and other supplies.
It’s not just college, either. You can pay for K-12 expenses (up to $10,000 per year) and even some registered apprenticeships.1 This means that whether the recipient is five years old or 55, they can experience some tax-free education.
For most people, 529 plans are a way for them to help get their children or grandchildren through college without breaking the bank and regardless of their tax bracket.
The tax benefits of 529 plans
Whether you’re thinking of starting a 529 plan (here are a few dos and don’ts) or you have one but perhaps haven’t leveraged its full benefits, there are several advantages 529 plans have when it comes to taxes.
1. Tax-free growth
From the time you contribute assets to a 529 plan to the time you distribute them, they grow tax free in the account. The earlier you start saving for your children or grandchildren’s education, the more you can potentially grow your dollar tax free.
2. Tax-free distributions
One of the biggest benefits of a 529 plan is that distributions from the plan are not taxed so long as they pay for qualified education expenses. If you pull money out for non-qualified expenses, you then must pay tax on the earnings as well as a 10% penalty.
What families with significant assets might want to consider in light of potential tax reform is to prefund the 529 plan using five-year gift tax averaging. You can gift an individual $15,000 a year without incurring the gift tax — $30,000 if you include your spouse. Multiply that $30,000 by five years, and you can prefund a 529 plan with $150,000 for a single beneficiary. This removes $150,000 from your estate — without using any of your lifetime estate tax exemption — and allows the money to grow tax-free over the course of the beneficiary’s childhood.
4. Tax deductions
Many states provide a tax deduction if you contribute to that state’s 529 program. For example, if you’re a resident of Illinois and you’re contributing to Illinois’ 529 program, you can deduct up to $10,000 of your 529 plan contributions if you’re single and $20,000 if you’re married filing jointly.2
Note that some states allow you to take the deduction no matter which plan you’re contributing to, but some states limit the deduction only to the person who is the account owner or the owner’s spouse.
Tax deductions vs. tax-free growth
What can sometimes be more significant of a benefit than your state’s tax deduction is the tax-free growth of the 529 plan. Each state’s program is different. Does the rate of return when contributing to another state’s 529 program outweigh the tax savings of contributing to your state’s 529 program?
Because you are allowed to contribute to any state’s 529 program, many people often contribute to state programs with lower expenses, a wider variety of investment options and a history of higher rates of return. If you’re already contributing to your state’s program but are thinking of switching, you are allowed to roll your plan over to another state’s program once a year.
This allowance has led to a unique strategy where, on an annual basis, you could contribute to your state’s 529 plan, gain the tax deduction and then roll the plan over to another state’s program that you believe would work better for you in the long run so your money can continue growing there.
Who qualifies as a 529 beneficiary?
So, there are quite a few benefits to creating and contributing to a 529 plan, but what happens if you overfund it? After all, it must pay for qualified education expenses if you want to avoid the 10% penalty.
Even if you find you’ve overfunded the 529 plan for the beneficiary, the rules around transferring the account to another beneficiary are liberal, and you can create quite the legacy for your family through funding a 529 plan. Qualified beneficiaries3 include:
- Your children (biological and adopted), stepchildren, foster children and any of their descendants
- Your siblings (includes stepsiblings)
- Your parents and any of their ancestors
- Your stepparents
- Your nieces and nephews
- Your aunts and uncles
- Your first cousins
- Your father-in-law, mother-in-law, sons-in-law, daughters-in-law, brothers-in-law or sisters-in-law
- Any spouse of the above individuals
Note that transferring the plan to a new beneficiary does not count as a gift.
What have recent regulations changed when it comes to 529 plans?
The benefits of grandparents owning 529 plans has expanded recently.
Before, any distributions made from a 529 plan owned by anyone other than the beneficiary or their parents was counted as income and reported on the beneficiary’s Free Application for Federal Student Aid (FAFSA®) form — potentially limiting financial aid eligibility.
Now, due to the Consolidated Appropriations Act of 2021, that’s no longer the case4 — providing extra incentive for grandparents to start 529 plans for their grandchildren. Other family members and even friends can now create and contribute to 529 plans without worrying they may decrease the beneficiary’s financial aid eligibility.
Another piece of legislation, the SECURE Act, added to the list of qualified 529 expenses. The first addition allows 529 funds to pay principal and interest on the beneficiary’s student loans up to $10,000. An additional $10,000 can be distributed tax-free to each of the beneficiary’s siblings, too.
The second addition allows 529 funds to cover registered and certified apprenticeship programs.
Ready to start your 529 plan?
529 plans are a great way to save for your family’s future education needs. When it comes to setting them up, relying on a professional can be valuable.
Professional advisors, such as tax CPAs or financial advisors, can help you evaluate the tax benefits of contributing to your state’s program versus another state’s; evaluate different states’ historical returns, expenses and investment options; determine the right annual contribution to help you meet your goals; and look holistically at how 529 plans fit into the full picture of your finances.
Wipfli Financial Advisors and our affiliate Wipfli LLP work hand in hand to make your 529 plan work for you and help ensure it’s part of an overall diversified financial plan that keeps you on track to meet your goals now and into the future. Contact us to learn more.