A tax-free college savings account, such as the Section 529 plan, can help individuals accumulate money to pay for college. With such accounts, the investor receives certain tax benefits that are not available through a personal or custodial account.
Section 529 plans are statesponsored plans designed to encourage families to save for college. Section 529 plans provide for tax-free withdrawals for qualified education expenses, including tuition and room and board. They also provide special estate and gift tax treatment that cannot be obtained through trust planning.
Contributions to a 529 plan are, by statute, considered completed, present interest gifts; the amount contributed, as well as future earnings the gift may ultimately generate, is removed from the grantor’s gross estate. However, if the grantor is also the account owner, he or she retains full control over, and access to, the money. This control, coupled with the special gifting provision described below, makes the use of a 529 plan a viable strategy for those who want to pass assets on to a desired beneficiary, such as a child or grandchild, without relinquishing control of those assets.
529 plan contributions are made with after-tax dollars and accumulate tax free. Anyone, regardless of age or income, can make contributions to a 529 plan on behalf of a beneficiary, even if the beneficiary is him- or herself.
Three limitations apply to contributions of a 529 account:
-Special gifting provision
Section 529 does not impose an annual contribution limit on 529 plans, so contributors must take care not to exceed the federal annual gift exclusion (currently approximately $14,400.00) defined in IRC Section 2503(b) when contributing to an account for someone other than themselves. To avoid gift tax and reductions in the applicable exclusion amount, contributors may take advantage of the annual gift exclusion per 529 plan beneficiary.
IRC Sec. 529(c)(2) allows a special gifting method that is not available in any other vehicle and allows for potential accelerated earnings within the tax-favored account. Under this provision, a contributor may gift five years’ worth of annual exclusion gifts in one year on behalf of a 529 plan beneficiary without causing a taxable gift.
Sponsoring states set account limits to prevent accumulation of more money than needed to send a beneficiary to college. Account limits vary by state, generally ranging from $235,000 to $453,000. Once the balance in a 529 plan reaches the account limit, new contributions cannot be made to the plan, although earnings may cause the account to exceed the limit.
Contributions to a 529 plan are not deductible from federal income tax. However, many states provide a state tax deduction or credit for residents who participate in their 529 plans. Six states, including Pennsylvania provide a state tax deduction for contributions made to any 529 plan.
Distributions used for qualified higher education expenses pertaining to the enrollment or attendance at an eligible educational institution are free from federal income tax and, in most cases, state income tax as well.
Examples of qualified expenses include the following:
-Tuition and fees
-Room and board (including off-campus housing, up to the cost of on-campus housing)
-Books, supplies and equipment, as required by the institution
-Expenses for special needs services required by a special needs beneficiary in connection with enrollment or attendance at an eligible institution
Distributions are made up of a proportionate amount of the principal (contributions) and earnings within the plan. If a distribution is taken from a 529 plan but not used for a qualified expense, the portion of the distribution repreSenting earnings is subject to ordinary income tax and a 10% federal penalty.
The 10% penalty does not
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Apply to distributions that are:
-Paid to a beneficiary, or to the designated beneficiary’s estate, on or after the designated beneficiary’s death
-Made because the designated beneficiary is disabled.
-Included in income because the designated beneficiary received veterans educational assistance, employer-provided educational assistance, a tax-free scholarship or fellowship, or other nontaxable payments designated for educational expenses (with the exception of gifts or inheritance).
-Made on account of the designated beneficiary’s attendance at a U.S. military academy, not to exceed the costs of education attributable to attendance.
-Included in income only because the qualified education expenses were taken into account in determining the American Opportunity or Lifetime Learning Credit.