The Tax Advantages of 529 Plans
Since 529 college savings plans were introduced in 1996, a growing number of parents and grandparents have taken advantage of the opportunity to salt away money for college and enjoy tax-free distributions.
As of mid-2014, the amount invested in 529 plans totaled $244 billion, according to the College Savings Plans Network, a consortium of state-plan operators. Compare that with the end of 1999, when investments in 529 plans totaled $5.75 billion. The group says a key factor in that growth is an increasing number of families participating in college savings programs.
A 529 plan allows an investor to contribute after-tax dollars earmarked for qualified higher-education expenses, including tuition and fees, books, room and board, and even computers and other supplies. Distributions for qualified higher-education expenses are free of federal income tax. On a state level, tax treatments differ. That's one of the reasons 529 plan investors should understand available tax strategies, accountants and plan advisors say.
Tom Corley, a certified public accountant in Rahway, New Jersey, and author of "Rich Habits: The Daily Success Habits of Wealthy Individuals," says making the decision to save regularly is the first step, even before you investigate potential tax benefits.
"You want to get into the habit of contributing to your child's college education plan right out of the gate," he says. He notes that many plans allow participants to invest as little as $25 per month, as long as they are making regular contributions.
When opening a 529 plan, it's crucial to understand what kind of tax benefit, if any, your home state offers. Most states, as well as the District of Columbia, offer residents some kind of income-tax deduction for contributions to their 529 plan. In the seven states with no income tax, there's no possibility of such a deduction. In addition, several states that collect income taxes offer no deduction for residents' 529 plan contributions.
Contributions to another state's 529 plan typically bring no tax deduction, but a handful of states offer what's called "tax parity." That means account owners get a deduction for 529 plan contributions to any state's program. Corley points out that a few states, such as Colorado, New Mexico, South Carolina and West Virginia, offer a tax deduction up to the full amount of the annual plan contribution.
"They are offering some pretty robust tax deductions," he says. "They're really trying to get people to save."
Corley has seen scenarios where people begin contributing to a 529 plan in one state and later move to a different state. In a case like that, which brings up questions about tax implications, he recommends getting expert advice, particularly if you invested in a direct-sold plan. "If you're on your own through a direct plan, you have to find a CPA or advisor who can research it for you," he says.
Even residents of states with no income-tax deduction should take advantage of 529 plans' tax-free distributions, says Peg Creonte, senior vice president of business development at Ascensus College Savings. The Newton, Massachusetts-based firm administers direct-sold and advisor-sold 529 savings plans and counts 17 states as clients.
"We see that as a big driver for everyone -- the opportunity to put your money into the market and get that appreciation and have all those earnings tax-free when you use them for qualified expenses at a university or trade school, or wherever your child or grandchild, or whoever it is you're saving for, decides to go," Creonte says.
Those tax-free distributions still apply if a plan owner needs to switch beneficiaries. That comes up in situations where the plan beneficiary gets a scholarship and doesn't need the money saved in the 529 plan. In those cases, there is generally no taxable event if the plan beneficiary is changed to another person in the family.
Ben Micham, a CPA and certified financial planner at Micham & McSwain CPA in Raleigh, North Carolina, says grandparents, in particular, should be aware of the estate-planning benefits of 529 plan contributions. He emphasizes the benefits for grandparents, since older generations often have a higher net worth than the generation with children still in school.
Specifically, college savings plan contributions allow wealthier taxpayers to take advantage of what's known as the gift-tax exclusion. It refers to money that may be gifted from one person to another, on an annual basis, without incurring the federal gift tax.
The current gift-tax exclusion amount is $14,000 per year or $28,000 for a married couple. One person can make a gift of $14,000 to as many people as he or she wishes, up to a lifetime exclusion of $5.43 million, as of Jan. 1, 2015. That total amount is $5.34 million for 2014.
However, the gift-tax exclusion also allows for a lump-sum contribution to cover five years' worth of gifting.
"For example, you can contribute $70,000, all upfront," Micham explains. "Wealthy people who need to gift should look at making those contributions to a 529 plan."
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