529 Plans

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If you have children and have considered saving for their future college education, you have likely heard of the 529 plan. The name of this college savings plan is taken from Internal Revenue Code § 529. It offers a tax-advantaged way to save now for the future cost of your child’s education.

It is important to note that, while a 529 plan is most often set up to save for a child’s future education, they can be set up for almost anyone, whether that be a grandchild, niece, or even yourself.

There are two main types of 529 plans: prepaid plans and savings plans.

Types of 529 Plans

The first type is the prepaid plan. A prepaid plan allows donors to purchase credits or hours from a university or a state in advance. These types of plans lack the flexibility of the savings plan described below in that they lock the beneficiary into attending a specific group of schools approved by the state administering the plan.

These types of plans do, however, offer protection against tuition inflation, which has significantly outpaced broader inflationary rates over the last several years. The returns can therefore, in that sense, be quite significant.

The second type of 529 plans is the savings plan, which allows the donor to invest money to be used later for qualified educational expenses. These types of plans generally function as an investment savings account with investments being made by the state or institution running the plan.

These plans also offer significant tax advantages. While the federal government does not allow tax deductions for contributions to the plans, many states—including Arkansas—do. In addition, the federal government allows the savings to grow tax-free, so long as the funds are used for qualified educational expenses.

Setting up a 529 plan should be done carefully, as many states offering tax benefits require that certain plans be utilized. I therefore recommend consulting your state plan’s website or, preferably, a competent tax advisor before setting up a plan.

Withdrawing Funds From the 529 Plan

As discussed above, funds withdrawn for higher educational expenses are tax-exempt. These include tuition, fees, books, supplies, equipment, and room and board, subject to various requirements and limitations. Funds that are withdrawn for any other purpose are subject to normal taxation and an additional 10% penalty.

Of course, saving for a child’s college early may result in a rather fortunate dilemma if the child receives a significant or full scholarship. The beneficiary of such a plan is not set in stone. If for some reason the beneficiary does not need the funds, the account holder—usually the person who established the plan—can change the beneficiary to a member of the beneficiary’s family. So, if your first child receives a full scholarship, you can simply make another child the beneficiary instead.

Gift and Estate Tax Benefits

A 529 plan also qualifies for special estate and gift tax benefits. In particular, five years worth of annual gift exclusions may be front-loaded as a single gift into the plan. So, assuming an annual exclusion amount of $14,000, you could make a $70,000 contribution to the plan upfront without owing any gift tax. In addition, donations to a 529 plan are not included in your estate at death for estate tax purposes, unless you die in the middle of a front-loaded gift period.

So, for example, if you were to give a $70,000 front-loaded gift to a 529 plan and then die later that year, only one year’s worth of the annual exclusion amount would be excluded from your estate. The amount of the gift is prorated, so $56,000 of the gift would still be included in your gross estate for estate tax purposes. If you lived for another five years, however, none of the gift would be included in your estate.

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See Also:

The Federal Gift Tax

The Federal Estate Tax