Saving for higher education tuition can be overwhelming, but it can be a little easier with the help of a college savings account. By saving earlier and more efficiently, you can increase your savings for education, whether it is for your children, a family member, or even yourself. One of the most popular types of college savings accounts is a 529 plan because of its tax benefits. Here is an overview of 529 plans, including what they are, how they work and other important information.
What is a 529 plan?
A 529 savings plan is a tax-sheltered investment account created exclusively for qualified higher education expenses. These plans are named after Internal Revenue Code Section 529 and are offered by states or educational institutions. Like a Roth 401(k) or Roth IRA, 529 plans enable families to invest after-tax contributions that not only grow tax-free but can be withdrawn tax-free if the funds are used to pay for qualified expenses.
What is a qualified higher education expense?
Qualified higher education expenses include tuition, fees, books, computers, equipment, internet services, and room and board for students who are at least half-time. Any withdrawals made to pay for these expenses must happen in the same year the expense is incurred. The IRS has also recently allowed 529 plan funds to pay for up to $10,000 of K-12 tuition as well as up to $10,000 in student loan debt. Purchases made with 529 plan funds that are not qualified expenses will be subject to a 10% penalty, plus regular income taxes.
Another thing to keep in mind when making withdrawals from your 529 plan is that you’ll want to avoid “double-dipping.” In other words, you are not allowed to use more than one tax benefit for the same expense. For example, if you used $3,000 from your 529 plan to pay for your child’s tuition, you may not also use this same expense to qualify for an education tax credit, like the American Opportunity Tax Credit. This is also the case if someone else paid for your child’s tuition with their own 529 plan. Another example is if your child receives a tax-free scholarship of $10,000 to put towards their $15,000 tuition bill. Because $10,000 was received, you may only withdraw up to $5,000 for this expense. Withdrawing more will result in a penalty.
What are the tax advantages of 529 plans?
Contributions to 529 plans are made with after-tax dollars, which means they are not federally tax-deductible. Some states allow you to deduct contributions. 529 plans, however, do grow tax-free, which means any earnings generated are not taxed, as long as the funds are ultimately used for qualified education expenses. This means your investments can grow faster with less effort on your part. Investing in a tax-deferred account, like a 529 plan, can yield thousands of dollars more than a taxable account.
529 plans can also be great for estate planning. For tax purposes, contributions to a 529 savings plan are considered completed gifts. Individuals can reduce their taxable estate and perhaps reduce estate taxes by contributing to a 529 plan. This is especially advantageous for those with significant assets who want to pass wealth down to future generations while minimizing the impact of taxes on their estates. These contributions are not taxed unless they exceed the annual gift tax exemption amount of $17,000 (in 2023).
What else should I know about 529 plans?
Sometimes, things don’t go as planned. If the funds are no longer necessary for higher education, but you still have leftover money, you have a few options. You can change the beneficiary on the account to another family member. You can also make yourself the beneficiary if completing higher education is a goal for you. Your 529 college plan can also be converted to a 529 ABLE plan, a savings account for people with disabilities. Finally, beginning in 2024, you will be able to roll over up to $35,000 of 529 funds into a Roth IRA, as long as the account has been open for at least 15 years.
Like Roth accounts, 529 plans have a lot of tax advantages. However, it’s crucial to follow all tax laws when making withdrawals and reporting education expenses during tax time. Keeping good records of qualified expenses and the amount of tax-free money received can help ensure that you stay compliant. As you can imagine, improper usage of this tax-deferred account can result in penalties that can cause financial hardship. Optima Tax Relief is the nation’s leading tax resolution firm with over a decade of experience helping taxpayers with tough tax situations.
Contact Us Today for a Free Consultation