Created in 1996 and named after Section 529 of the Internal Revenue Code, these are qualified tuition plans meant to provide tax advantages to those saving for higher education expenses. There are two types of 529 Plans, the College Investment Plan and the Prepaid College Trust.
529 College Investment Plan: Each state sponsors a 529 College Investment Plan, but you aren’t required to contribute to your state’s plan. However, depending on your state, there could be tax incentives to in-state participants. For example, if you are a Maryland resident and file a Maryland state tax return, up to your first $2,500 in contributions per beneficiary to Maryland’s 529 plan may be state tax deductible. Unlike IRA accounts, there is no income cap or phaseout for qualifying for the potential deduction.
There is a special tax consideration for 529 Plans. You could front load up to five years of annual gift exclusions ($15,000 for 2018) per beneficiary ($75,000 for 2018 per person, or $150,000 per married filing jointly couple) in one year without triggering a gift tax. Note: if you contribute under this strategy you may not contribute again for 5 years.
A key change to the tax code beginning in 2018 is that now 529 plans can be used to fund up to $10,000 a year per beneficiary for Kindergarten through high school provided that the funds are used for qualified expenses. You should verify that your state’s plan has adopted this K-12 change as not all states have updated their plans at the time of this writing. Note: many plans permit immediate withdrawals after contributions, so the plans could in effect serve as a conduit to obtain a potential state income tax deduction and then be used immediately to pay tuition. Please check the specific plan provisions, fees, and expenses before considering such a strategy.
How does it work?
As an account owner, you may establish a 529 account and begin making contributions. Most state plans now have online enrollment available. Anyone can contribute to the 529 account. In fact, some states allow the account owner to set up an online “gifting portal” which makes it very easy and convenient for others to contribute to your 529 account. The funds grow tax-deferred, and distributions on earnings are tax-free (based on current tax law) if used for qualified expenses. If you are a Maryland resident and open a new 529 College Investment account before June 1, 2018, the state will make a matching contribution for those under certain income thresholds. Visit maryland529.com/MDMatch250 for more information.
What are considered “qualified expenses” and who keeps track of this?
It’s important to consult the IRS website each year for a list of qualified expenses because they are subject to change. Generally, tuition and mandatory fees are qualified. Room and board is usually a qualified expense, but more research may be necessary. It starts to get more complicated when things like off-campus housing come into the picture. Required course materials and textbooks are qualified, but again, be careful. The required books are qualified, but the study guide that is recommended may not be qualified. The responsibility of proving the funds were used for what the IRS considers a qualified expense is on the account owner’s shoulders in a tax audit situation. That’s why it’s extremely important to document each expense in the clearest way possible. Keep all receipts and a best practice is to separate all qualified expense purchases from non-qualified expenses. It’s not a good idea to co-mingle the required laptop on the same receipt as the big screen TV! It’s also a good idea to print any documentation the school provides indicating that the item you are purchasing with 529 funds is required.
529 Prepaid College Trust: There are some states, Maryland being one of them, that offers a 529 Prepaid College Trust Plan option. From the IRS’s standpoint, the Prepaid and Investment 529 plans are treated the same in terms of any state tax deductions for contributions and tax breaks on distributions. However, with the pre-paid college trust plan, the objective is to lock in future tuition expenses today. If you think college tuition costs are likely to rise in future years, investing in this plan may be a good strategy. The latest you can invest in the Prepaid Trust is three years before benefits are expected to start. Unlike the 529 Investment Plan, Prepaid Trust dollars can only be used for tuition and mandatory fees. To obtain additional information on the Maryland Prepaid College Trust, visit maryland529.com.
What happens if the beneficiary doesn’t go to college?
With either 529 plan, you can change the beneficiary to certain members of your family, without tax consequences. There is no time limit to use 529 Investment Plan funds, but with the Prepaid Trust, the beneficiary can delay benefits only up to 10 years after the projected year of college enrollment plus any years spent in active military. If a distribution is made that is not considered qualified, there would be a 10% penalty on the amount of the non-qualified distribution and income tax is due on any money earned on the investments.
If saving for retirement and college are goals, what should I focus on first?
Everyone’s financial situation is different, and in some situations, it may be advisable to borrow for college expenses rather than neglect your retirement goals. After all, borrowing for college is an option for you or your child while borrowing for retirement isn’t so easy. Work with a financial advisor to develop a financial roadmap and prioritize these goals with your others. As with any investment account, be sure you understand all fees associated with the plan. 529 plans may not be for everyone and they aren’t the only option you have to save for education expenses. Consult your financial advisor and tax professional for more information.
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