CPE

Understanding Section 529 plans: A guide for tax practitioners

August 8, 2024

529 Plan tax benefits with image of a graduation cap and glasses

Section 529 plans offer a convenient opportunity to save for future education costs, but there are several factors to consider when choosing a plan. Whether you’re a parent looking to save for your child’s education or a tax professional seeking to understand these plans better, we’re providing an in-depth look at what these plans are, the different types, and the Section 529 plan tax benefits available.

What is a Section 529 plan?
Section 529 plan tax deductions
Best states to start a 529 plan
Contribution limits
Taxation upon withdrawal
Usage beyond college expenses
Potential downsides of a 529 plan

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What is a Section 529 plan?

A Section 529 plan, a qualified tuition program (QTP) named after Section 529 of the Internal Revenue Code (IRC), is a tax-advantaged savings plan designed to encourage saving for future education costs. While parents or grandparents primarily open 529 plan accounts for their children or grandchildren, anyone, regardless of their income or relationship to the student beneficiary, can open one.

These plans can be used to cover educational expenses from kindergarten through graduate school and have expanded to include apprenticeship programs, student loan repayments, and even Roth IRA contributions under certain conditions.

Types of 529 Plans

There are two types of 529 Plans:

Prepaid tuition plans, which allow the purchase of tuition credits at today's prices
Education savings plans, which allow investments to grow tax-deferred and be withdrawn tax-free for qualified education expenses.

Both plans offer flexibility in changing beneficiaries and can be used for various educational expenses, including private school or college tuition, room and board, and other mandatory fees.

Section 529 plan tax deductions

You can't deduct 529 plan contributions at the federal level. They are typically sponsored by states, and the states may offer 529 plan tax benefits for contributions to their state's plan. This can offer a significant tax advantage for residents contributing to their home state's 529 plan on their state tax return.

While some states require residency to use their 529 plans, most don't. However, contributing to a plan in your home state may offer additional benefits. It's a good idea to compare options nationwide before opening an account or advising a client.

Best states to start a 529 plan

As mentioned above, you're not limited to investing in your home state's plan. However, you may receive 529 plan tax deductions or credits by staying local. Some states offer tax parity, meaning residents can receive a state income tax deduction for contributions to any state's plan.

To find out about your state's 529 plan tax benefits, you have a few options:

Visit the official state website or the state's 529 plan website. Most states provide detailed information on their plan websites about details like tax benefits, contribution limits, and other relevant information.
Use a 529 plan comparison tool, such as the one provided by Vanguard, to view state tax breaks and compare your state's 529 plan tax benefits against others.

We recommend you review the most current information by contacting the plan provider directly.

529 plan contribution limits

The federal government does not establish annual contribution limits for 529 plans. Instead, states have the authority to set these limits. However, contributions must be, at most, the expected cost of the beneficiary's qualified education expenses. Taxpayers can contribute over $200,000 per beneficiary in every state with some states allowing contributions over $500,000.

If contributions exceed the gift tax exclusion amount ($18,000 per year in 2024 or $36,000 for a couple), there may be gift tax consequences. However, individuals may make a one-time lump-sum contribution of up to $90,000 in 2024 ($180,000 per couple) without incurring gift taxes if they spread the contribution over five years. These high contribution limits allow for substantial savings for future educational expenses and may generate greater earnings over the life of the investment.

Taxation upon withdrawal

Withdrawals from a 529 plan are not taxed at the federal level if used for qualified education expenses. These expenses include tuition, fees, books, and room and board. However, if the withdrawals are not used for qualified expenses, they are subject to income tax and a 10% penalty on the earnings portion of the withdrawal.

There are exceptions to the penalty, including situations where the beneficiary receives a scholarship, becomes disabled, or attends a U.S. Military Academy. Furthermore, if the student receives a refund from the school for expenses paid by the 529 plan, the amount can be recontributed to the plan within 60 days without penalty The taxable portion of non-qualified withdrawals must be reported on the beneficiary's income tax return.

Using a 529 plan beyond college expenses

529 plans are versatile and can be used for various educational expenses beyond college, such as K-12 tuition, apprenticeship programs, and up to $10,000 in student loan repayments. The SECURE Act of 2019 and the SECURE 2.0 Act of 2022 expanded the usage of 529 funds. Now, funds can be used for various educational institutions, including public, private, and religious schools, trade and vocational schools, graduate schools, and online degree programs.

The SECURE 2.0 Act, signed into law on December 29, 2022, introduced significant changes to 529 plan withdrawals. One crucial change allows for the tax-free rollover of unused funds from 529 accounts to Roth IRAs, effective for distributions after December 31, 2023. Beneficiaries of 529 plans can roll over up to $35,000 (lifetime limit) to a Roth IRA, subject to annual contribution limits, provided the 529 account has been open for over 15 years. However, contributions made to the 529 plan within five years of the rollover date are ineligible for transfer. This change offers greater flexibility in managing unused 529 funds, potentially reducing the tax burden on non-qualified withdrawals.

Potential downsides of 529 plans

While there are significant 529 plans offer many tax advantages, there are some potential downsides to consider:

Non-qualified withdrawals can lead to taxes and penalties.
Investment options within 529 plans may be limited compared to other investment accounts.
If the beneficiary does not need the funds for education, changing the beneficiary or rolling the investment over to a Roth IRA (if the account is at least 15 years old) are options. However, they come with their own rules and limitations.
Investing in a 529 plan may reduce a student's eligibility for need-based financial aid.
The plan may not be suitable for someone with a child about to enter college in less than two to four years, as traditional mutual funds might offer lower expenses and better short-term investment options.

In conclusion, Section 529 Plans are a valuable tool for tax practitioners to consider when advising clients on education savings. They offer flexibility and tax advantages and have been expanded to cover a wide range of educational expenses. However, it is essential to be aware of these plans' specific rules and potential drawbacks.

Learn more about 529 plan tax benefits and more with Becker CPE

While this article provides a foundational understand of Section 529 plan tax benefits, you can gain added insight and knowledge into this topic with the following CPE course, What Every Tax Practitioner Needs to Know about Section 529 Plans. Or to expand your tax knowledge related to education, check out Maximizing Higher Education Tax Credits.