529 Plans: Learn the Tax and Financial Planning Benefits of College Savings

  • Personal finance
  • 9/25/2023
Family strolling in the late afternoon in the city park

Key insights

  • A 529 plan can be a great option for college (and some K-12) savings. These plans not only provide tax free earnings but offer other advantages.
  • There are many rules involving contributions and withdrawals so it’s important to learn the details. Starting in 2024, unused 529 funds may be rolled into a Roth IRA for the beneficiary without incurring penalties or taxes, assuming certain guidelines are followed.
  • When implemented properly, 529 plans can be an attractive financial planning tool that may reduce gift and estate taxes.

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Like so many items these days, college is getting increasingly expensive. Starting to save early can be a big help, especially if you look at investment opportunities offering tax free growth.

A 529 plan is not only a potential useful tool in your overall financial plan, but it can also offer many tax advantages. Read on to find out about the contribution and withdrawal rules and how 529 plans can impact financial aid. When considering how it may fit into your financial goals, there may also be federal and state tax benefits along with gift and estate tax benefits if you implement your 529 plan correctly.

What is a 529 plan?

A Section 529 plan is a tax-advantaged savings plan designed to encourage saving for education expenses. Contributions to a 529 plan grow tax-free, and withdrawals for qualified education expenses, such as tuition, fees, books, and room and board, are tax-free distributions.

Types of 529 plans

There are two types of 529 plans: prepaid tuition plans and college savings plans. Prepaid tuition plans allow you to pay for future tuition at today’s rates, while 529 college savings plans allow you to allocate funds in various investment options. Consider just a few of the options:

  • State-sponsored 529 plans — All U.S. states have their own state-sponsored 529 plans. (Note: Wyoming only offers a 529 ABLE plan.)
  • Brokerage 529 plans — These accounts are 529 plans held directly at a broker-dealer custodian.
  • Pre-paid tuition 529 plans — These plans allow you to pay for some or all of the tuition of public in-state schools. They can also be used at some private and out-of-state institutions.
  • ABLE 529 plan — This is a specific type of tax-advantaged savings plan designed to help individuals with disabilities and their families save money for disability-related expenses. The term ABLE stands for “Achieving a Better Life Experience” and the plan is similar to the 529 college savings plan. To be eligible for an ABLE 529 plan, the beneficiary must have a significant disability that occurred before age 26.

529 plan contribution and distribution rules

Contribution and withdrawal rules

Any adult can open and contribute to a 529 plan, including any member of a beneficiary’s family or friends. You are even eligible to contribute to a 529 plan owned by someone else. For instance, a parent may make contributions to a grandparent-owned 529 account for their own child. However, each plan can only have one beneficiary at a time. Each child needs their own 529 plan.

Contributions must be made in cash.

Withdrawals are tax-free when used for qualified education expenses. New legislation continues to expand the definition of education expenses, but generally, they’re defined as tuition, fees, technology, and room/board.

Any withdrawal not used for qualified education expenses are considered “nonqualified” withdrawals. The earnings on nonqualified withdrawals are generally subject to income taxes and a 10% penalty.

State-sponsored 529 plan regulations will vary, including contribution limits and tax deductions. Most 529 plans do not have state residency requirements and you can generally open accounts in as many states as you want, regardless of where you reside or where the beneficiary eventually attends school. Over 30 states currently offer tax deductions or credits for 529 plan contributions. Depending on your tax situation, one state will likely be more beneficial than another.

Contribution levels should be based on the anticipated cost of the beneficiary’s education expenses. Each state sets the contribution limits of their individual plans — often between $250,000 and $550,000 — and the combined contributions for any one beneficiary cannot exceed the limit.

For example, a parent and a grandparent cannot both set up an account for a single beneficiary in the same state and each have their own $550,000 limit. However, contribution limits don’t generally cross state lines, and funding one state’s 529 plan may not count toward the limit in another state.

Investment strategy

Contributions to a 529 plan may be made in a single lump sum or contributions over time. Once funds are contributed, these plans generally offer a range of investment options.

When selecting your investment options, consider the beneficiary’s age and risk tolerance. Just like any other investment account, your investment advisor can help select the appropriate allocation for the beneficiary.

Unused funds

There is no penalty for leaving unused funds in a 529 plan after the beneficiary graduates. However, distributions for nonqualified expenses — even following a beneficiary’s graduation — are subject to income tax and withdrawal penalties.

Options for unused funds include changing the plan beneficiary to another individual planning to attend college in the future.

Additionally, under the Secure 2.0 Act of 2022, beginning in 2024, unused 529 funds may be rolled into a Roth IRA for the beneficiary without incurring penalties or taxes. This rollover is subject to a lifetime limit of $35,000, and the contributions must comply with the annual IRA limits ($6,500 for most, $7,500 for those over age 50). The 529 plan must have been opened for more than 15 years to use this option.

How 529 plans can affect financial aid

The 529 plan assets owned by parents are treated as a parental asset when completing the Free Application for Federal Student Aid (FAFSA). Parental assets are generally treated favorably on the FAFSA and have a low impact on reducing financial aid eligibility.

Beginning with the 2024, 529 plans owned by other family members (e.g., grandparents) will not negatively impact financial aid when completing the FAFSA.

Estate considerations involving 529 plans

When implemented properly, 529 plans can be an attractive estate planning tool that may reduce gift and estate taxes. Consider two concepts — the lifetime gift and estate tax exemption and the annual gift tax exclusion.

  • Lifetime exemption — The amount the IRS allows an individual to gift without paying federal gift and estate taxes. An estate with a value above the exemption limit at an individual’s passing is subject to estate taxes.
  • Annual gift tax exclusion — A threshold up to which an individual can make annual gifts without using lifetime exemption or paying a gift tax. Any gifts valued above the annual exclusion, require a gift tax return and reduces your lifetime exemption.

In 2023, the annual gift tax exclusion is $17,000 per person and the federal lifetime exemption is $12.92 million. (On December 31, 2026, this limit sunsets to approximately $6.4 million.) Additionally, 13 states impose a state estate tax on top of the federal estate tax.

Contributions to 529 plans are removed from your estate. Therefore, an individual may annually contribute up to the annual exclusion and not reduce their lifetime exemption or require a gift tax return.

For example, grandparents may gift $34,000 to each grandchild’s 529 account annually and not cut into their individual $12.92 ($25.84 combined) million lifetime exemptions. In a situation where there are 12 grandchildren, and grandparents contribute up to the annual exclusion, these contributions could total over $400,000 each year.

The IRS also allows individuals to make a single lump sum contribution equaling five years’ worth of 529 contributions of the annual exclusion amount, or $85,000 in 2023.

Using this rule, a grandparents may contribute for this five-year period and make a single lump sum contribution of $170,000. However, no other gifts can be made to this beneficiary during that five-year period, including gifts outside of the 529 plan, without using lifetime exemption. If a married couple makes gifts from only one spouse’s assets (i.e. from a revocable trust), they will be required to file a gift tax return to elect to split gifts. Additionally, if donors wish to make five years of contributions in one year, they will be required to file a gift tax return to elect to spread the contribution over the five-year period.

By gifting up to the annual exclusion limits during your lifetime, and effectively decreasing the value of your estate, you may dramatically reduce your exposure to federal and state estate taxes at your passing.

How we can help

529 plans can be a great investment vehicle to help meet your financial planning goals, but the rules are complex and changing. Consider the advantages of a 529 plan as part of a well-designed financial plan and with potential tax benefits in mind.

CLA wealth advisors and tax professionals are here to help. Reach out to discuss your individual situation, and which rules apply.

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