529 plans, created in 1996 in Section 529 of the Internal Revenue Code, have firmly established themselves as a cornerstone of college savings in the United States, offering a tax-advantaged pathway to save for future educational expenses. These plans function similarly to a Roth IRA. While contributions are not federally tax-deductible, in many cases, contributions may be deductible at the state level. More importantly, the account enjoys tax-free growth on both income and appreciation, and withdrawals for qualified education expenses such as tuition, room and board, and required fees, books, and supplies remain untaxed.
However, a notable aspect of the 529 plan that sometimes raises concern with our clients is the 10% penalty levied on “non-qualified withdrawals.” This penalty becomes relevant if there are surplus funds beyond what the beneficiary requires for their college education. If the plan owner withdraws leftover funds, then the portion of the withdrawn amount attributed to appreciation would be taxable as ordinary income and have a 10% federal penalty applied unless an exception exists. Income tax and penalties would not apply to withdrawals of the original contributions.
To address concerns around leftover funds and to expand upon the potential avenues for funding and utilizing 529 plans efficiently, we have compiled this report to delve into potentially optimal strategies for high-net-worth investors to leverage 529 plans effectively. Additionally, we’ve outlined recent legislative updates designed to mitigate the risk of facing potential non-qualified withdrawals down the road.
Types of 529 Plans
There are two varieties of 529 plans: prepaid tuition plans and education savings plans.
- Prepaid Tuition Plans: These plans allow you to prepay tuition at eligible colleges and universities at today’s prices for use in the future. They may also cover mandatory fees and sometimes room and board. Prepaid tuition plans typically offer a guaranteed rate of return, protecting against tuition inflation. However, these plans are less flexible as to school choice, as they are usually limited to fully covering tuition at in-state schools for that state’s plan. This creates some financial risk if the plan beneficiary attends an out-of-state school. The prepaid tuition plan may provide a smaller financial benefit or rate of return for out-of-state schools, based on each plan’s terms. Accordingly, these plans are somewhat less popular than the more traditional college savings plans.
- Education Savings Plans: Also known as college savings plans, these accounts, sponsored by state governments, function more like investment accounts, allowing you to contribute money that is then invested in a variety of mutual funds or other investment options made available within each plan. As noted earlier, the money in the account grows tax-free, and withdrawals are tax-free when used for qualified education expenses for any eligible educational institution (including some schools abroad). You are not limited to investing in your own state’s 529 plan — almost every state has a plan available to non-residents — nor are you limited to attending schools in-state. However, a state income tax deduction on contributions is often limited to contributions to one’s own state’s plan. Most of the commentary below will speak to these more traditional 529 plans rather than the prepaid tuition plans.
The Benefits of 529 Plans and Recent Updates
529 plans offer significant benefits that make them an attractive option for families looking to save for educational expenses. As mentioned earlier, one of the key advantages is their tax benefits. Earnings within a 529 plan grow tax-free, and withdrawals for qualified education expenses are also income tax-free at the federal level. Distributions are often treated as tax-free at the state level as well1. Additionally, many states provide full or partial state income tax deductions for contributions to their state’s 529 plans.
There is also a built-in flexibility within a 529 college savings plan, offering the ability to use the funds at eligible educational institutions nationwide, including colleges, universities, trade schools, and even some international institutions.
Another significant benefit held by account owners is the flexibility to change the beneficiary to another eligible family member if necessary. This ensures that the funds can still be used for educational purposes without penalty if, for instance, the original beneficiary of the plan does not pursue higher education, or receives a scholarship to attend school, or if the 529 plan was overfunded. In those cases, rather than incurring penalties and taxes on appreciation by making a non-qualified withdrawal from the plan, the beneficiary of the 529 can be changed to another child or relative for their use instead. Qualifying family members include the beneficiary’s siblings, cousins, step-siblings, spouse, in-laws, or the beneficiary’s own children, among other eligible beneficiaries.
In addition, since 2017, successive revisions to the tax law have broadened the scope and utility of 529 plans as a college savings vehicle, including:
Use for K-12 Education
In 2017, the federal law changed to expand the use of 529 plans, allowing those funds to be used to cover up to $10,000 per child per calendar year for K-12 education expenses. This provides an added benefit to parents or grandparents who wish to use 529 plans to help pay for private school. However, not all states match the federal tax treatment for distributions for K-12 withdrawals, so it is prudent to research or ask a tax professional for the state tax impact of 529 plan withdrawals for your particular state, even if it is permitted federally.
Student Loan Repayments
In December 2019, the first SECURE Act made another expansion to the list of qualified expenses: 529 plans can now be used to repay some of a beneficiary’s student loans, encompassing both federal and most private loans, up to a lifetime limit of $10,000 per beneficiary. This new federal law also permits loan payments with the same $10,000 limit towards loans held by the beneficiaries’ siblings, further easing the financial strain on the family. Note, however, that not all states permit such student loan repayments from 529s, or such payments may have a tax effect at the state level. In addition, be aware that student loan interest deductibility may be affected to the extent a loan payment was made from a 529 plan.
Secure Act 2.0: Rolling a 529 Plan Over to a Roth IRA
Under the SECURE Act 2.0, effective in 2024, up to $35,000 over a beneficiary’s lifetime can be rolled from a 529 plan for their benefit into a Roth IRA for the beneficiary, which allows leftover 529 plan funds to assist in saving for the beneficiary’s future retirement. However, the 529 plan must have been open for at least 15 years, the beneficiary themselves must have taxable income, and the amount that can be rolled into the Roth IRA is limited to the lesser of the Roth IRA contribution limits for that year ($7,000 in 2024 for those under 50) or the beneficiary’s actual earned income. Therefore, if a beneficiary earns at least $7,000 per year, it would take five years to roll over $35,000 of 529 funds into a Roth IRA.
Forward Funding and Contribution Limits
There are limits to what can be contributed each year to a plan, which is based on the annually published “annual exclusion” gift amount, which limits how much one can gift to another person every year without it being counted as a “taxable gift” for transfer tax purposes. As of 2024, the annual exclusion limit is $18,000 per individual, so normally one would be likewise limited to $18,000 per year per 529 plan beneficiary, less any gifts otherwise made to that individual that year. However, a special rule allows forward funding of the plan for up to 5 years at once, amounting to $90,000 per person in 2024 (assuming no other gifts are made for the next five years). This allows for a lump sum to be made early in the beneficiary’s life and grow tax-free for a longer period of time. Regardless of whether initially fully forward-funded, as the annual exclusion increases with inflation over time, additional gifts can be made in those intervening years to use up the rest of the annual exclusion amount.
As noted above, it is important to be aware that utilizing the annual exclusion limit restricts its use elsewhere for the designated child, which is particularly relevant for clients with Irrevocable Life Insurance Trusts (ILITs) where the 529 plan beneficiary is also an ILIT trust beneficiary. Clients with ILITs should seek advice to ascertain the portion of ILIT premiums considered gifts to the child, thus managing annual exclusion effectively.
Although there are also maximum contribution limits to 529 plans, typically, the limits are very generous, often exceeding $400,000-$500,000 per beneficiary, depending on the specific plan.
Financial Aid Considerations
One of the first questions we receive from clients about 529 plans is the impact of 529 plans on any potential financial aid down the road; clients worry that saving for college might actually be counterproductive in financial aid calculations. This becomes relevant when parents begin filling out the Free Application for Federal Student Aid (“FAFSA”), the form used by U.S. students to apply for federal financial aid for college, encompassing grants, work-study opportunities, and loans. The FAFSA has been greatly simplified as of 2024, with only about one-third as many questions as in prior years.
Although 529 plans owned by parents are counted as parental assets and are indeed factored into financial aid eligibility, the repercussions are not as negative as one might suppose. This is because only up to 5.64% of parental assets (including parent-controlled 529 plans) can be counted as available for student aid, contrary to student assets, including student-owned 529 plans, which are counted as 20% available for college-related expenses. In addition, distributions from parent-owned 529 plans do not count as income to the child. Accordingly, parent-controlled 529 plans are not as detrimental to financial aid calculations as one might initially fear, especially if one assumes that the tax-free growth over time would exceed that 5.64% inclusion rate in the end, and that other parent-owned, non-tax-favored assets are included as available for college expenses at the same maximum 5.64% rate.
As of the simplified FAFSA this year, if a student’s parents are divorced or separated, aid will be calculated with the income of the parent providing more of the financial support, instead of focusing on the custodial parent, as done previously. Going forward, therefore, the parent providing more financial support would file the FAFSA. In addition, if that parent has remarried, their spouse’s income and assets will also be relevant in aid calculations.
The Grandparent Loophole
Both for administrative and financial aid reasons, clients also ask whether it is better for grandparents to own 529 accounts, or whether the parent should own them. Under the prior FAFSA version from 2023 and before, 529 plans owned by grandparents were not reported on the FAFSA, which is good for aid eligibility. Still, on the negative side, payments from grandparents counted as student income in subsequent years, with the FAFSA assuming 50% of the gift value would be available for college the following year. In the past, it was better to receive grandparent gifts or grandparent-owned 529 plan distributions only in the last year or two of college to avoid the negative impact.
In good news, however, the new simplified FAFSA, applicable for 2024 and beyond, no longer penalizes students for grandparent-owned 529 plans, as the shorter FAFSA no longer asks about gifts received from grandparents. That being said, grandparent 529s may still be considered on the CSS Profile, another financial aid form sometimes used by private colleges in conjunction with the FAFSA to determine financial aid. All in all,529 plans can have a minimal impact on financial aid eligibility, making them an attractive option for families.
What if My Child Doesn’t Go to College?
Of course, college is not for everyone, and there can be a lot of circumstances in which a child or grandchild takes a different path in life. Fortunately, the Tax Cuts and Jobs Act of 2017 expanded the usage of 529 plans to include expenses for qualified education at vocational schools, trade schools, and other postsecondary institutions that meet the criteria set by the Internal Revenue Service (IRS).
Qualified expenses at vocational schools that funds can cover from a 529 plan include tuition, fees, books, supplies, and equipment required for enrollment or attendance at the institution. Room and board expenses may also be covered by a 529 if the beneficiary is enrolled at least half-time.
It’s important to verify that the vocational school is eligible under the rules governing 529 plans and to keep records of expenses to ensure that withdrawals from the plan are used for qualified purposes. Consulting with a financial advisor or tax professional can provide further guidance on utilizing a 529 plan for vocational school expenses.
In addition, all the same flexibility noted above as to other 529 benefits still apply. For example, using the 529 plan for K-12 private school, if applicable, or changing the beneficiary to a sibling, or rolling some into a Roth IRA when the child begins working. Alternatively, parents could let the 529 plan continue to grow tax-free until the child has their own children and change the beneficiary down a generation to the grandchild level at that time.
Is a 529 Plan Better than Establishing an Education Trust?
529 Plans offer unparalleled advantages for education-focused savings, particularly when college attendance is anticipated. 529 Plans offer a dedicated and tax-efficient solution tailored to the specific needs of funding higher education.
That said, there is nothing wrong with creating a trust for the benefit of the child and/or other family members as well, as trusts may serve broader purposes or accommodate a broader range of potential investments without being limited to plan choices. If the primary focus for creating a trust is to cover educational costs, then it is probably the less efficient solution, as the trust will not allow for the tax-free growth benefits, and a trust will never allow the grantor to take leftover funds back for themselves, unlike 529 plans, which allow the owner to reclaim the funds, albeit with a penalty and tax on appreciation. However, if the goal of a trust is to allow those funds to be protected from creditors, to be out of the grantor’s estate, and to have a wider variety of potential distribution reasons beyond only educational expenses, then a trust can be a more versatile solution beyond education funding alone.
Ownership Structure
When establishing a 529 plan for a beneficiary, there are two ways that the ownership of the account can be set up, although it may vary by plan:
- Individual Ownership
- Under this structure, the account is established in the name of an individual account owner, typically a parent, grandparent or guardian that is depositing the funds into the account, although it can receive contributions from other family members as well. The plan is established for the benefit of a specific beneficiary, usually a child or other family member. The account owner retains control over the account and can make decisions regarding contributions, investments, and withdrawals, and has the right to change the beneficiary, which can be advantageous if the funds are not fully utilized by the original beneficiary, in which case a new beneficiary can be established to utilize the remaining funds. Because of the retention of control by the owner, this can also be a beneficial structure in the event of a divorce.
- Custodial Ownership
- Custodial ownership involves establishing the account in the name of a custodian (usually a parent or guardian) for the benefit of, and on behalf of, the designated beneficiary. However, unlike individual ownership, the custodian cannot change the beneficiary of the account, as the funds are considered held on behalf of the child, versus truly owned by the custodian. If funding is coming from an UTMA (Uniform Transfer to Minors Act) or UGMA (Uniform Gift to Minors Act) account for the child’s benefit, this type of 529 plan might be required. Control of the plan generally changes once the beneficiary reaches adulthood (usually 18 or 21 years old, depending on state law), and may permit the beneficiary to take action on the account. Until then, the custodian manages the account on behalf of the beneficiary.
Conclusion
As shown above, there are significant advantages to 529 plans in general, including tax-free growth, tax-free withdrawals for qualified educational expenses, and the ability to change beneficiaries. In addition, recent expansions to the permitted uses of such plans increase plan flexibility by permitting K-12 distributions, partial student loan payments for beneficiaries and siblings, and rollovers to Roth IRAs, all of which reduce the likelihood of having leftover funds in 529 plans. High and ultra-high net worth clients can also strategically forward-fund such plans by carefully navigating annual exclusion limits, especially for clients with Irrevocable Life Insurance Trust (ILIT) trusts. These plans offer unparalleled tax benefits and flexibility, making them superior choices for college savings when compared to alternative vehicles such as trusts.
At NewEdge Wealth, our commitment lies in guiding you through the complexities of wealth management, ensuring that your financial strategies are tailored to align seamlessly with your aspirations and priorities.
Sources
1Several states do tax 529 distributions for K-12 educational expenses, which are permitted federally of up to $10,000 per calendar year, but the states don’t tax withdrawals for higher education. Alabama considers any distribution from a non-Alabama 529 plan to be a non-qualified distribution, which is therefore taxed. Source: https://www.savingforcollege.com/article/states-that-do-not-conform-with-federal-529-plan-tax-laws.
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