posted by: Radnor Financial Advisors
As the year draws to a close and individuals are considering what year-end tax and financial planning strategies may be appropriate, 529 contributions should be at the forefront of the conversation for those with children and grandchildren.
529 accounts are a popular and tax-efficient vehicle to save for college. At both the federal and state levels, investments within a 529 plan can grow and be distributed tax-free. Additionally, many states offer tax benefits for residents that contribute to their state’s 529 plan.
State Tax Benefits
Below is just a partial list of states that offer an upfront tax benefit for contributions:
Connecticut – You may deduct up to $5,000 ($10,000 if filing jointly) for contributions made to the Connecticut 529 plan.
Maryland – You may deduct up to $5,000 ($10,000 if filing jointly) per beneficiary for contributions made to the Maryland 529 plans. Note that there are two separate plans: the Maryland Prepaid College Trust and the Maryland College Investment Plan. The maximum deduction is $2,500 for each account per beneficiary. There is a 10 year roll-forward for contributions in excess of $2,500 per account per year.
New York – You may deduct up to $5,000 ($10,000 if filing jointly) for contributions made to the New York 529 plan.
Pennsylvania – To the extent you make 529 contributions, Pennsylvania offers a state income tax deduction of $15,000 per beneficiary per spouse to the extent the individual has income.
Ex. Cody and Meredith have two children, Jaden and Jackie. If each parent contributes the annual gift exclusion amount in 2019 (see below), they combine to contribute $30,000 to each child’s 529 account ($60,000 total). If both Cody and Meredith report $100,000 of income on their Pennsylvania return (total gross income of $200,000), they can fully deduct the $60,000 of 529 contributions from their taxable income that year as the contributions were less than their respective incomes.
If Meredith reports $100,000 of income but Cody only reports $10,000 of income, they can only claim a deduction of $40,000. Meredith is able to able to deduct full $30,000 but Cody can only deduct $10,000 for the contributions as he only reported $10,000 of income.
Unlike most states, Pennsylvania allows you to take a deduction for contributions to other states’ 529 plans. However, Pennsylvania does offer some incentives for its residents to invest within the state’s own plan. For a Pennsylvania resident, assets held within a PA 529 plan 1) are exempt from Pennsylvania inheritance tax, 2) are not considered when determining state financial aid, and 3) are protected from creditors in Pennsylvania.
Some states that currently do not offer any state tax incentives are California, Delaware, Massachusetts, and New Jersey. It also follows that those states without an income tax generally cannot offer a state income tax deduction.
Each state has different tax benefits and requirements for 529 contributions. Visit your resident state’s 529 website to learn more about the requirements and tax benefits available.
Qualified Education Expenses
Distributions from 529 accounts are non-taxable if used for qualified higher education expenses. Qualified education expenses include:
The following are not considered qualified:
The Tax Cuts and Jobs Act added a provision that expands the definition of qualified expenses to include primary and secondary education expenses capped at $10,000 annually. Such expenses include those related to public and private schools, but not homeschooling.
Distributions for nonqualified expenses will be subject to income tax and a 10% excise tax on the portion of the distribution in excess of original contributions. For example, if a distribution of $1,000 is made from a 529 account with a balance of $10,000 consisting of $8,000 from contributions and $2,000 of appreciation, $200 of the $1,000 distribution would be subject to income and excise taxes.
Documentation supporting the qualified expenses, such as Form 1098-T issued by educational institutions, should be maintained. The IRS can, and frequently does, request that taxpayers provide documentation pertaining to nontaxable 529 distributions and the corresponding qualified expenses. If the expenses cannot be substantiated, the IRS may assess income tax and excise tax on the distributions as well as penalties and interest.
Estate and Gift Tax Compliance
Contributions to 529 accounts are considered gifts to the account beneficiary. As such, contributions are subject to the gift tax reporting requirements. The current annual exclusion amount is $15,000 per spouse per child. A married couple can combine their annual exclusions – known as gift-splitting – to gift up to $30,000 to each child. Contributions above that would require that a gift tax return be filed.
If you are in a position to contribute a large lump sum to a 529 plan, you are allowed to make a “5-year election.” This allows a parent to contribute up to $75,000 per child (up to $150,000 when a couple gift-splits) in Year 1 and apply the gift against the annual gift tax exclusions for Years 1–5. The parent(s) will need to file Form 709 to report the election. Fortunately, barring any other gifts to the beneficiary, the taxpayer does not need to file in Years 2–5.
As with any tax-advantaged account, certain strategies may – and should – be employed to maximize the benefits of a 529 account.
For parents with multiple children, some level of strategy may be employed when contributing to each child’s 529 account. Once a contribution has been made to a 529 account, those funds can be transferred back and forth between 529 accounts tax-free. This allows the parents to frontload an older child’s 529 account (potentially via a 5-year gift) to close the gap between the current savings and projected costs. Then if some of the 529 funds are not needed for the older child’s education, the excess funds can be shifted to a younger child’s account. This process can be repeated indefinitely and is especially helpful for families who were not able to save for college until their children were in high school. A similar strategy for families with children already in college would be to contribute the annual gift limitation to each child’s 529 account and then shift funds around as needed to cover each child’s expenses.
529 plans are generally considered to be used as a long term plan to save for college. However, the state tax benefits can be leveraged to effectively increase short-term returns on funds already earmarked for tuition. For example, it may not seem worth it to open a 529 account and make a contribution just to withdraw the funds a year later to cover tuition. However, if you are in a state with 529 tax benefits, consider investing funds earmarked for short-term educations expenses in a conservative fixed-income fund custodied in a 529 account. The funds would earn a small return and the contributions would result in a tax deduction of the marginal tax rate. Hypothetically, 3% tax savings added to a conservative return of 2% would result in a net return of 5%.
Even though the intent of the 529 plan is to save for the cost of education, there is no requirement that distributions from a 529 account be used for educational expenses. There is simply a 10% excise tax on the appreciation portion of distributions not used for qualified expenses. In the current low interest rate environment, certain 529-custodied guaranteed fixed income funds may offer attractive interest rates even after accounting for the excise tax. For example, a 529 account yielding 2%would yield a net return of 1.8%. If traditional high-yield savings accounts are only offering 1.5% interest rates, utilizing a 529 account as a de facto high-yield savings account or as component of the investment portfolio’s fixed-income allocation may be attractive. Depending on the state tax laws, the state tax deductions for contributions may still apply.
Selecting a 529 Plan
When determining which 529 plan in which to invest, there are a few key questions to consider:
What is your state income tax rate? If your state income tax rate is low and/or there is a low cap on deductible contributions, there may be less incentive to invest in your own state’s plan just to claim the deduction than if your state tax rate and/or deductible contribution limitation is higher.
What are the annual performance rankings and expense ratios of the plan? For those who live in states with no state income tax, no state tax benefits for 529 contribution, or that allow deductions for contributions to out-of-state plans, one should look for plans with funds that have low expense ratios and good performance metrics when compared to other state plans.
Is this 529 plan state-sponsored? Not all 529 plans are sponsored by a state. Certain financial institutions custody 529 plans that are not affiliated with any specific state. While contributions to such a plan grow tax-free, these plans may be more expensive and may not be eligible for a state tax deduction.
On its face, a 529 account is fairly straightforward: open an account to benefit your future college student and your contributions will grow tax free. With proper planning and understanding, one can maximize the benefits of a 529 plan to the fullest extent to save for college as well other educational and non-educational expenses.
Author: Mike Valenti, Senior Tax Associate