A 529 plan is a tax-advantaged account designed to help families save for a beneficiary’s educational expenses. The rules for such plans—formally known as qualified tuition programs—are defined in Section 529 of the Internal Revenue Code. The basic premise is that assets in a 529 plan grow tax free, and withdrawals are tax free as long as they are used for qualified education expenses. 529 plans are a more tax-advantaged way to save for education expenses compared with other savings vehicles, such as Uniform Transfers to Minors Act (UTMA) or Uniform Gifts to Minors Act (UGMA) accounts, which do not grow tax free. Here is everything you need to know about the tax treatment of 529 plans.
529 plans are offered by the various states, with each state determining the plan structure and investments. Often, a state income tax deduction for contributions is available if you’re using your state’s 529 plan, though a federal tax deduction is never allowed for contributions. View this state-by-state list of state tax deductions or credits for contributions to 529 plans to determine what’s applicable in your state.
Earnings in a 529 plan grow tax free and will not be taxed upon withdrawal as long as they are used for qualified education expenses. Tax-free withdrawals now include up to $10,000 per year per beneficiary for tuition for K–12 private, public, or religious schools. In addition, 529 plans are now permitted to cover expenses related to any registered apprenticeship program and have a $10,000 lifetime limit for withdrawals to pay down student loans. (The $10,000 limit applies to a beneficiary of a 529 as well as a
$10,000 limit for each sibling).
A 529 account owner is able to withdraw funds from a 529 plan anytime for any reason; however, the earnings portion of any nonqualified withdrawal will be subject to income tax and a 10 percent penalty. (Contributions and earnings are deemed to be distributed on a pro-rata basis.)
Exceptions to the 10 percent penalty, where the penalty will be waived even when a nonqualified distribution occurred, include:
- When the distribution occurs as a result of a tax credit adjustment
- When the beneficiary receives a tax-free scholarship, veterans, employer, or other tax-free educational assistance
- When the beneficiary attends a U.S. military academy
- When the beneficiary dies or becomes disabled
Minimal Tax Reporting
Minimal tax reporting is required for 529 plans. Contributions aren’t reported on your federal return and, as of 2022, contributions of up to $17,000 ($34,000 for a married couple) qualify for the annual gift tax exclusion. You can also front load a 529 plan with up to five years of annual exclusion amounts at one time with no gift tax consequences.
Upon taking a distribution, a Form 1099-Q will be generated and sent to the appropriate taxpayer. As long as the distribution was for qualified expenses, no tax liability would be associated with the distribution.
The 1099-Q shows the total distribution amount, the portion allocable to contributions, and the portion allocable to earnings in the event the distribution is taxable.
There are other situations relating to 529 plans that should not trigger adverse tax consequences. Amounts can be rolled over from one 529 plan to another once during a 12-month period. The account beneficiary can be changed to another qualifying family member of the beneficiary without tax consequences. If you’re considering changing the 529 account owner, however, exercise caution. Most state plans allow for a change of ownership, with no requirement about the relationship between the former and new owner. Some state plans may only allow a change of ownership when the original account owner dies or in special situations such as divorce.
Qualified Educational Expenses
It’s not always clear what constitutes a qualified educational expense. IRS Publication 970 is the primary source to determine tax benefits for education, though it doesn’t deal with every situation. Qualified education expenses include tuition, fees, books, supplies, and equipment, as well as expenses for special needs services—these expenses must be required for, or incurred in connection with, enrollment or attendance at an eligible postsecondary school.
Qualified expenses may also include the purchase of computer or peripheral equipment, computer software, internet access, and related services if used primarily by the beneficiary when enrolled at an eligible postsecondary school. Expenses for room and board qualify only if:
- The student is enrolled at least half-time
- Room and board costs are not
- Larger than the greater of the amount charged by the school for living on campus, or . . .
- Larger than the allowance as determined by the school in its estimated cost of attendance used for financial aid purposes.
Please note: Some states may not align with what is considered a federal qualified withdrawal for items such as K–12 tuition. In addition, some states have income recapture rules where a deduction allowed in one year may be required to be reported as income in a subsequent year.)
Items that are typically considered nonqualified expenses include the following:
- Transportation and travel costs: Not qualified, even for out-of-state students or for travel to and from campus during holidays
- Health insurance: Not qualified, even for a plan provided by the school
- Extracurricular activity fees: Only tuition costs and fees are qualified; additional activity fees are not (unless a required part of attendance)
- Student loan payments: In excess of lifetime limit of $10,000
- Application and testing fees: Preparatory fees not qualified; fees must be associated with current enrollment
For more information about 529 plans, see the Qualified Tuition Program section of IRS Publication 970. If you have questions relating to the taxation of 529 plans, please consult your financial advisor and tax professional.
For questions about how a 529 Plan might fit into your financial plan, schedule a complimentary consultation with Hawekotte Financial Group here.
The fees, expenses, and features of 529 plans can vary from state to state. 529 plans involve investment risk, including the possible loss of funds. There is no guarantee that an education-funding goal will be met. In order to be federally tax-free, earnings must be used to pay for qualified education expenses. The earnings portion of a nonqualified withdrawal will be subject to ordinary income tax at the recipient’s marginal rate and subject to a 10 percent penalty. By investing in a plan outside your state of residence, you may lose any state tax benefits. 529 plans are subject to enrollment, maintenance, and administration/management fees and expenses.