529 Savings Plans are tax-advantaged accounts used to pay for qualified education expenses. Contributions are typically invested in target-date funds, gradually shifting toward a more conservative allocation as the beneficiary nears college age.
You may be considering a 529 for your child, grandchild, or another family member. Here are some of the more common questions we hear from our clients regarding 529 accounts.
1. What are the tax advantages of 529 Savings Plans?
Contributions to 529s are not tax deductible for federal purposes. However, there may be some state tax benefits, depending on your state’s income tax and the 529 Plans available in your state.
Contributions and earnings grow federally and state-tax-free, provided withdrawals are used to pay qualified expenses.
2. What expenses can I pay with a 529?
Qualified education expenses include:
- College tuition
- Room and board (subject to limits set by the college)
- Mandatory fees, plus any required material for classes (such as books or computers)
- Tuition and qualified expenses of apprenticeship programs
- Studying abroad (typically)
- $10,000 a year for K-12 tuition costs (for certain states only)
- A lifetime maximum withdrawal of $10,000 to pay down student loan debt
We recommend using the 529 to cover higher education expenses. The beneficiary will benefit from compounding years of tax-deferred growth the longer the funds remain invested in the account. If the 529 plan account balance exceeds the estimated amount of college expenses or costs that will be covered by another means, we may recommend using the plan to cover K-12 tuition.
Follow this link for a complete list of 529-eligible universities in the U.S. and abroad.
3. Which 529 Plan should I use, and is there a benefit to using my state’s plan?
Each state has its own 529 Plan, so the answer varies depending on where you live and the plan’s quality. Over 30 states, including Oregon, currently offer a state income tax credit or deduction for 529 Plan contributions. Click here to see a summary of the different state tax benefits.
While most states require using their own plan to receive the tax benefit, seven states, including Arizona, currently provide residents with tax benefits for contributions to any state plan. In most of these states, anyone contributing to a 529 Plan is eligible for the tax benefit. However, six states limit the tax benefit to account owners and their spouses only.
States like Washington and California offer residents no state tax incentives for 529 contributions, so residents can use any state plan they choose.
4. What happens if I withdraw funds to pay for non-qualified expenses?
Typically, you would pay income tax and a 10% federal tax penalty on plan earnings.
5. What happens to the 529 Account if the beneficiary gets a scholarship?
529s may be used to pay expenses not covered by the scholarship, such as books and supplies. The plans can also be used for post-graduate education or transferred to the beneficiary’s relative for higher education expenses.
If you have leftover funds, you can withdraw up to the scholarship amount without penalties, but you must pay income tax on any investment gain. In this case, consider having the 529 distributions paid to and reported by the student, as they are potentially in a lower tax bracket. However, this strategy requires changing the ownership of the 529 Account, which may have tax implications.
6. Do I need to keep records of the 529 withdrawals for my taxes?
We recommend keeping receipts to document that the funds were spent on qualified expenses in case of an audit. However, this proof is seldom needed for tax preparation and withdrawals from the 529 Plan.
To ensure receipts match up easily, we recommend withdrawing funds from the 529 in the same tax year your costs were incurred.
7. Does it matter who is named as the account owner?
The person establishing the account is listed as the owner, receives account statements, and manages the investments. Therefore, withdrawals will be reported on the owner’s tax return. However, anyone can make contributions to the account.
It is important to note that ownership of the account will impact financial aid calculations under the FAFSA process, which determines a family’s ability to pay for college before receiving any awards. Under FAFSA, a family is expected to contribute 5.64% of assets owned by parents. In contrast, assets owned by nonparent family members (such as grandparents, aunts, uncles, etc.) do not impact the calculation (as of 2022). However, nonparent 529 plans are still considered part of the CSS Profile, which private colleges and universities use to award financial aid.
It may be possible to avoid the higher assessment by switching ownership away from the parents before withdrawals begin or waiting until the final years of college to use the assets in the parent-owned 529. Be sure to check your plan’s rules before opening the account.
8. Can I change the name of the beneficiary on my 529 Plan?
Yes, most plans allow transfers to a “family member.” For instance, if a couple’s oldest child receives a scholarship, they could reassign funds to anyone related to the child, such as siblings (including a stepbrother or stepsister), parents, grandparents, first cousins, aunts, and uncles.
9. Is there a limit to how much I can contribute to a 529?
Yes, the limit varies by state, ranging from $235,000 to $550,000. We typically recommend spreading plan contributions over several years to stay within the annual tax-free gifting limits to avoid filing a gift tax return:
- An individual can currently gift up to $16,000 per year per child
- A married couple can gift up to $32,000 per year per child
Note: 529 Savings Plans allow a special one-time contribution worth up to 5 years of annual gifts. This contribution would require filing a gift tax return, but no gift tax would be incurred.
10. What other strategies are available if I am concerned about overfunding a 529 Account?
- Continue to save and invest within your taxable account.
- Consider gifting appreciated securities to adult children attending college or graduate school. If they are in a low tax bracket, they may be able to sell the stock without paying capital gains tax.
Disclaimer: This article has been provided for informational purposes only and should not be considered as investment advice or as a recommendation. This material provides general information only. Coldstream does not provide any specific tax or legal advice; you should consult your tax, legal, or other advisors before implementing any changes to your current financial situation.
To ensure compliance with requirements imposed by the IRS, we inform you that any federal tax advice contained in this communication (including attachments) is not intended or written to be used and cannot be used for (1) avoiding penalties imposed under the Internal Revenue Code or (2) promoting, marketing or recommending to another party any transaction or matter addressed herein unless the communication contains explicit language that it is a tax opinion in compliance with IRS requirements. Please contact your tax advisor for guidance on your individual situation.