Changes to 529 Education Savings Plans Create Tax Planning Opportunity
With the passage of the Tax Cuts and Jobs Act this past December, families with children in public, private, or religious schools can now use 529 education savings plans to pay for a child’s primary and secondary school (“K-12”) tuition. The new changes are a particular boon to Pennsylvania residents, where contributions to such plans are deductible on Pennsylvania state income tax returns. However, residents of all states can benefit from the changes to the federal tax code by using the tax-free withdrawals permitted by such plans to help underwrite a child’s K-12 education.
Below is a short question-and-answer style explanation of the new law and what you need to know to take advantage of it.
(1) What is a 529 Education Saving Plan?
A 529 Education Saving Plan is a type of education investment plan which provides its beneficiaries with certain tax benefits that can be used to pay for certain education-related expenses. There are generally two types of plans: (1) educational institution-run plans (generally set up by a college or university) and (2) state-run investment plans. With respect to the former, families would have the option of contracting into an institution’s current tuition schedule, with the idea that tuition is likely to be cheaper now than in the future. Thus, families would invest in the plan now as a means of pre-paying the tuition due at a later date.
With respect to state-run plans, states generally contract with a private bank to set up a qualified 529 plan. These banks then contract with families to set up an individualized 529 plan for the benefit of a given child and families and friends can then contribute money to the child’s plan. These contributions are then invested by the financial institution in some mix of money market funds, mutual funds, or other investment vehicle depending on the family’s investment goals and time horizon for when withdrawals are likely to be made. Thereafter, the plan’s beneficiary (the child) can make tax-free withdrawals from the plan to pay for qualified educational expenses such as tuition, books, or room and board.
(2) Who Can Contribute to a 529 Plan? Are There Any Contribution Limits?
Anyone may contribute as much as they want to a 529 plan, but amounts over the federal gift tax limit ($15,000 per individual or $30,000 for married individuals filing jointly) will be subject to the federal gift tax of between eighteen (18%) to forty (40%) percent depending on the amount contributed. This tax will be paid by the donating party and requires a separate gift tax filing with the Internal Revenue Service. However, there is no tax effect to the beneficiary of a 529 plan.
(3) What Has Changed Under the New Tax Law?
Previously, contributions made to a 529 plan could only be withdrawn to pay for certain expenses such as tuition, fees, books, supplies, and equipment required for enrollment or attendance at an eligible college or university. It also includes (a) expenses for special needs services required for enrollment or attendance, (b) room and board for all students who attend a college or university at least half-time, and (c) expenses for the purchase of a computer or related equipment, internet services, or software, provided all are used primarily in connection with a beneficiary’s education.
The new tax law tax law now allows 529 plans to pay for up to $10,000 of a student’s tuition at a public, private, or religious K-12 school. This new change was made effective January 1, 2018, meaning that families can now use money invested in a 529 plan to pay for a child’s K-12 education beginning this semester.
(4) What Does This Change Mean From a Financial Perspective?
Assume for example that the Jackson family makes $250,000 a year in combined income. Upon the birth of their son Tim, they open a 529 account and name Tim the plan’s beneficiary. Immediately thereafter, the Jacksons and their friends and family combine to contribute $10,000 dollars and they continue to make a $10,000 investment for each of the next 17 years until Tim is ready to go off to college. Assume further that their investment grows at a flat rate of 6 percent a year and beginning when Tim is 4 years old, the Jackson’s withdraw the maximum $10,000 a year to pay for Tim’s K-12 education at a private religious school. Once Tim turns 18 and is ready to head off to college, he will not only have had the benefit of his K-12 education being subsidized by the federal tax code, but he will still have more than $125,000 left in his 529 plan that he can use to pay, completely tax-free, for his college education. See the chart below for more details:
With Six Percent Growth
This also does not account for any state-level tax savings that the Jacksons would be eligible for. Assume further that the Jackson parents are married, file their taxes jointly, and live in Pennsylvania, where contributions to 529 plans are deductible up to the annual federal gift tax threshold ($15,000 per individual or $30,000 for spouses in 2018). If the Jacksons themselves contributed the entire $10,000 per year to Tim’s 529 plan, and assuming that Pennsylvania state income tax rates remain at the same 3.07% for all 18 years, they will have saved a combined $5,526 in Pennsylvania income taxes (about $307 a year). This would help offset, at least in part, other areas of the tax reform law (such as the federal $10,000 limitation on the deduct-ability of state and local taxes) that may have otherwise caused the Jackson’s taxes to go up starting this year. Unfortunately though, this benefit is not available to New Jersey residents, as contributions to 529 plans are not deductible from New Jersey state income taxes.
(5) What if my child does not need or does not use all of the money in his 529 plan account?
In that case, you would have two options. First, you could simply change the beneficiary of the plan to any of the following people:
- Your spouse
- Your in-laws (including mother-in-law, father-in-law, brother-in-law, or sister-in-law);
- Your children (including step-children, foster children, and adopted children);
- Your siblings (including step-siblings);
- Your nieces and nephews;
- Your aunts and uncles; or
- Your first cousins.
Of course, each of these people would then need to use the money in the 529 plan account to pay for their own education expenses. Alternatively, you could also choose to withdraw the remaining amount in the account and pay a 10% fee plus any other federal income tax due on the investment growth.
(6) What If I Already Have a Coverdell Education Savings Account to Pay for My Kid’s K-12 Education Expenses?
Prior to this year, the only federally tax-exempt savings account that could be used for K-12 educational expenses were Coverdell Education Savings Accounts (“Coverdells”). However, to be able to create a Coverdell, you could not earn more than $110,000 a year ($220,000 if married and filing jointly), you were limited to only $2,000 in contributions to a Coverdell annually, all contributions had to be made before the child turned 18 years old, and all money had to be used before the child turned 30 years old, unless the child had a qualifying disability.
Obviously, the smaller contribution limits and the limitations imposed on the parents creating a Coverdell make them significantly less attractive than a 529 plan now that such plans can pay or up to $10,000 a year in K-12 education expenses. Thus, the new tax bill permits families who currently contribute to a Coverdell to roll over any money currently in a Coverdell to a 529 plan. This additional wrinkle can save many families hundreds, if not thousands, of dollars in taxes that would have otherwise been paid upon a rollover and should make things significantly more streamlined for families who do not want to juggle multiple K-12 investment accounts.
(7) What If I Create a 529 Plan and Later Learn That My Child Has a Disability and I Want to Move That Money to a More Flexible Investment Account?
In 2014, Congress authorized the creation of 529 ABLE plans which were used by parents with children who have disabilities to pay for certain disability-related expenses. Prior to that time, if a child with a disability earned more than $700 a month or had $2,000 or more in savings, this would jeopardize that person’s ability to access certain public benefits necessary for their disability, such as Medicaid. Congress created 529 ABLE plans to help erase this fiscal trap for families with a disabled child, and 529 ABLE plans are now a commonly used vehicle to pay for such expenses as health care premiums and costs, job training programs, and financial planning services, in addition to education-related expenses of the disabled child.
The problem historically with traditional 529 plans is that once created, a transfer or rollover to a 529 ABLE plan would cause the tax-free nature of the withdrawal to disappear, and beneficiaries would have to recognize any gain that accrued on the investment plus an additional penalty of ten (10%) percent. Thus, if a family started a traditional 529 plan and later learned that their child had a disability, they could not then roll over the traditional plan into a 529 ABLE plan without having to pay Uncle Sam. The new tax law now allows for a one-time tax-free rollover of a traditional 529 plan into a 529 ABLE plan. This one new wrinkle alone could save a family thousands of dollars and removes an otherwise artificial barrier between two otherwise similarly situated and related types of tax-free investment plans.
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