One of the most powerful college savings vehicles is the 529 college savings plan. It allows you to make significant contributions with money that accumulates tax-free in these programs as long as you follow all relevant tax laws. The money in 529 plans can be used to pay for any college-related expenses, including tuition and fees, room and board, textbooks, and computers used for school. Money can be used to pay for either undergraduate or graduate programs.
There are many things to like about 529 plans, however, there are also some reasons why it might not be the best option for you.
Tax-free earnings if used on qualifying expenses
Broad definition of qualifying expenses
High contribution limits
Can start saving decades before beneficiaries reach school
Possible state tax deductions on contributions
Penalties on nonqualifying expenses
Impact of gift tax on large contributions
Unpredictability of market returns
Tuition hikes that exceed market growth
Maximum Contribution Limits
The IRS limits plan contributions to no more than what is necessary to pay for a beneficiary's qualified educational expenses. As state-sponsored programs, each state sets limits on how much can accumulate in 529 accounts. Most base the limit on the total expected cost of higher education at eligible institutions.
In New York, for example, contributions can be made into the account until the beneficiary has $520,000. The account can still continue to grow once the limit has been reached but new contributions would not be allowed. Other states have similarly high limits. California sets the maximum at $529,000 and Michigan allows up to $500,000.
To find the maximum allowed amount in any state, get a current copy of that state’s disclosure booklet. These numbers change from time to time, so always verify for yourself before making any investment decisions.
Gift Tax Issues
You can save a lot of money in a 529 plan, but adding funds too quickly can create complications. The “gift tax” limits how much money can move from one person to another before the IRS gets involved. Spouses who are both U.S. citizens can give each other unlimited amounts, but contributions to a 529 plan for a child, grandchild, or another individual might be considered gifts, and those gifts can affect your current or future taxes.
Individuals are allowed to gift a certain amount each year before triggering gift tax issues. This amount, known as the annual exclusion is $15,000 for tax years 2018–2020 and applies to the individual making the gift—not the recipient. So a married couple filing a joint tax return could potentially give up to $30,000 without triggering gift tax issues.
Giving More Than the Maximum
You’re free to gift more than $15,000 to the same person in one year. However, you must remember to report the gift to the IRS on Form 709, as it is required. You won’t necessarily need to pay taxes on the gift as it may potentially apply to your lifetime gift tax exclusion.
For 529 contributions, the IRS allows up to five years’ worth of contributions at once with the potential to avoid gift tax consequences. An individual could contribute $75,000 (or $150,000 for a married couple) to a beneficiary’s 529 in one lump sum, but your IRS Form 709 must reflect your option to take the five-year election.
This is a powerful way to jump-start a savings plan. However, rules can be complicated and it’s easy to accidentally “overlap” gifts and give too much. The contribution of additional gifts within the five-year election of exclusions period may trigger tax consequences.
Alternately, if the individual who made the contribution dies within that five-year period, their estate may need to count a portion of the contribution for estate tax purposes.
If you make payments outside of a 529 plan directly to a higher education institution for tuition expenses, those payments are generally not subject to gift taxes. That’s not much help if you’re socking away money for a newborn, but it could be helpful for parents or grandparents to help out while a child is in school. This strategy isn’t perfect because it’s useful for tuition payments only. Money for room and board or other expenses may be treated as a gift. Keep in mind, too, that it may affect the student’s ability to get financial aid.
Limits on Deductions
Another limit worth noting is the extent to which you get current-year tax benefits. In some states, filers may be eligible for a state income tax deduction on contributions to 529 plans. State tax deduction availability will vary by state and each state in the union can have different deduction rules and limits.
The primary goal of a 529 account is to build assets for future expenses, so you may not care what the limits are. However, it’s always good to know how much you can benefit from making contributions, and you don’t want to claim a deduction that you’re not allowed to claim.
For example, New York state taxpayers using a New York 529 plan may be able to deduct up to $5,000 (or $10,000 for married couples filing jointly) on their state tax returns. Illinois doubles those amounts (a married couple can deduct up to $20,000), and some states allow you to deduct the full amount of your contributions. To complicate matters further, some states base the limit on the taxpayer claiming the deduction, while others apply separate limits for each beneficiary. Contributing to multiple beneficiaries could provide a higher total deduction.
Contributions to a 529 beyond the gift tax exclusion might not qualify for a federal income tax deduction, but that’s not to say that federal benefits are nonexistent. Earnings inside of a 529 are not taxed annually, and all of the earnings can potentially come out tax-free if the money is used for qualified higher education expenses. Of course, if the funds aren't used for qualified expenses, income tax and penalty taxes may be charged on the earnings.
Consult a Tax Professional
States often make changes to 529 plan rules. Before making big decisions or taking action with your money, consult with a local tax advisor and a financial planner familiar with the rules in your state. It’s always better to prevent problems before they happen by consulting with an expert.