529 plan


A 529 plan, also called a qualified tuition program, is a tax-advantaged investment vehicle in the United States designed to encourage saving for the future higher education expenses of a designated beneficiary. In 2017, K–12 public, private, and religious school tuition were included as qualified expenses for 529 plans along with post-secondary education costs after passage of the Tax Cuts and Jobs Act.

Overview

529 plans are named after section 529 of the Internal Revenue Code—. While most plans allow investors from out of state, there can be significant state tax advantages and other benefits, such as matching grant and scholarship opportunities, protection from creditors and exemption from state financial aid calculations for investors who invest in 529 plans in their state of residence. Contributions to 529 college savings plans are made with after-tax dollars. Once money is invested in the account, it grows tax-free, and withdrawals from the plans are not taxed when the money is used for qualified educational expenses. Only 2.5 percent of all families had 529 college savings accounts in 2013. As of August 2020, more than $360 billion was invested in 529 college savings plans.
There are two types of 529 plans: prepaid plans and savings plans.
  • Prepaid plans
  • * Prepaid plans allow one to purchase tuition credits at today's rates to be used in the future. Therefore, performance is based upon tuition inflation.
  • * Prepaid plans may be administered by states or higher education institutions.
  • * Currently, nine states provide a prepaid tuition plan that is accepting new applicants. Those states include Florida, Illinois, Massachusetts, Michigan, Nevada, Pennsylvania, Texas, Virginia, and Washington.
  • Savings plans
  • * Savings plans are different in that all growth is based upon market performance of the underlying investments, which typically consist of mutual funds and exchange-traded funds. Investors can select stocks and bonds via preset investment menus.
  • * Most 529 savings plans offer a variety of age-based asset allocation options where the underlying investments become more conservative as the beneficiary gets closer to college age.
  • * Savings plans may be administered by states only.
  • ** Although states administer savings plans, record-keeping and administrative services for many savings plans are usually delegated to a mutual fund company or other financial services company.
With the Economic Growth and Tax Relief Reconciliation Act of 2001, 529 plans gained their current prominence and tax advantages. Qualified distributions from 529 plans for qualified higher education expenses or tuition for elementary or secondary schools are exempt from federal income tax.

History

529 college savings plans originated from states rather than the federal government. With tuition cost increasing year by year, the state-run prepaid tuition program of Michigan addressed the increasing anxiety on the part of many thousands of Michigan households with the Michigan Education Trust proposition. This created a fund to which the state's residents could pay a fixed amount in exchange for tuition increases. The initiative sparked interest in other states, which launched their first prepaid tuition program.
Michigan delayed its own launch so that a ruling could be requested from the Internal Revenue Service regarding the tax aspect of arrangement. The IRS allowed purchasers of the "prepaid tuition contract" to not be taxed on the accruing value of the contract until the year in which funds were distributed or refunded. Additionally, the trust fund established by the state of Michigan was required to receive prepayments and be subject to income tax on earnings from the invested funds.
The Michigan Education Trust entered into prepaid tuition contracts with Michigan's residents. An estimated 55,000 individuals signed up for the program. MET paid federal income tax on its investment earnings, and in 1990 filed suit for refund from the IRS. The case was first decided in favor of the IRS, but on appeal in 1994 the Sixth Circuit Court of Appeals reversed the district court judge's decision and found in Michigan's favor.
At one point MET sold prepaid tuition contracts that were below market value, and the program had to be adjusted with appropriate pricing. Today it remains as one of the largest and most successful pre-paid programs.
Subsequently, Congress has passed new legislation authorizing qualified state tuition programs. This is now part of the Small Business Job Protection Act of 1996. Section 529 was added to the Internal Revenue Code, conferring tax exemption to qualifying state programs and deferring tax on participant's undistributed earnings.
Section 529 advanced to the Clinton administration's agenda and became part of Taxpayer Relief Act of 1997. The TRA made changes such as deduction on student loans, penalty-free IRA withdrawals for higher education, and adding room and board to the list of qualifying expenses.
Another provision was added to the bill to make Section 529 distributions tax-free, not just tax deferred when used for college. Bill Clinton vetoed this provision.
In 2001, when George W. Bush was president, new tax bills were crafted in both the Senate and the House of Representatives containing the previously vetoed changes.
With limited Democratic support, the Economic Growth and Tax Relief Reconciliation Act of 2001 was signed into law on June 7, 2001. Beginning in 2002, however, the Act now exempts those withdrawals from income taxation provided they are used for qualified higher educational expenses.
Due to federal budget constraints, EGTRRA stated that every tax provision within the new law would expire on December 31, 2010. Congressional leaders decided to insert a provision in the Pension Protection Act of 2006 that would make all EGTRRA charges to Section 529 permanent, including tax-free treatment for qualified distributions.
Changes to the structure and marketing of 529 plans over the years have contributed to their growth. The states partnered up with the professional investment community, which allowed them to offer 529 plans with the feel of mutual funds. Also, registered brokers and investment advisors can directly assist families in understanding 529 plans and selecting an appropriate investment.
Other changes that have resulted in a growth in adoption include: federal legislation regarding taxes, financial aid, asset protection; on-going program improvement; lowering of expenses; generous state incentives; positive media coverage; and college savings registries that allow people sign up for the program. Some employers offer 529 plans to their employees as a benefit, similar to retirement plans, or even with contribution matching.
In 2014, Congress passed the Achieving a Better Life Experience Act, laying the groundwork for ABLE accounts. ABLE, or 529A, accounts are similar to 529 plans, except for the purpose of saving for a disabled beneficiary's special needs.
In his 2015 State of the Union address, President Obama proposed removing the tax-free status of distributions of 529 plans. He abandoned the proposal after it met with heavy opposition.
The Tax Cuts and Jobs Act of 2017 expanded 529 plans to include K–12 public, private, and religious school tuition. The original plan, called the Cruz amendment, called for homeschool expenses to also qualify for 529 plans, but the homeschool expenses provision was removed in the Senate reconciliation process, while the K–12 tuition provision was retained. According to the new law, 529 plans can be used to fund all K–12 school tuition costs up to $10,000 per year per child. The SECURE Act further expanded the use of 529 plans to cover student loan repayments. The Tax Cuts and Jobs Act also allowed rollovers from 529 plans to ABLE accounts, as long as the ABLE account beneficiary is the original 529 beneficiary or a qualified family member. The allowed annual rollover amount is set at the standard IRS gift tax exemption, less any other contributions made in the current tax year.
The SECURE 2.0 Act of January 2023 allows for tax and penalty-free rollovers from 529 accounts to Roth IRAs, under certain conditions. Beneficiaries of 529 college savings accounts would be permitted to rollover up to $35,000 over the course of their lifetime from any 529 account in their name to their Roth IRA. These rollovers are also subject to Roth IRA annual contribution limits, and the 529 account must have been open for more than 15 years.

Use for qualified education expenses

The funds from a 529 plan are used for qualified education expenses. These expenses are typically tuition, fees, textbooks, computers and equipment and are charged to the student in relation to attending an institution defined as any eligible public, non-profit or private college or university, technical, vocational, or trade institutions. Expenses for special needs services needed by a special needs beneficiary must be incurred in connection with enrollment or attendance at an eligible post-secondary school or institution as described previously. For expenses to qualify, the student must be enrolled for at least half the full-time academic workload for the course of study the student is pursuing, as determined under the standards of the school where the student is enrolled. Institutions are considered eligible if they participate in a financial aid program administered by the U.S. Department of Education. This may also include some foreign educational institutions located outside of the United States, but they must be eligible to participate in a financial aid program administered by the U.S. Department of Education as well.
Additionally, as determined by state law, eligible expenses of no more than $10,000 of tuition incurred by a designated beneficiary enrolled in elementary or secondary school may be used at any eligible public, private or religious school that provides elementary or secondary education.
Room and board are also considered eligible expenses for both on-campus and off-campus housing. For on-campus housing – the expense allowed is the actual amount charged if the student is residing in housing owned or operated by the school. For off-campus housing – the expense is allowed up to the amount allowed for on-campus room and board, as determined by the school, that was included in the cost of attendance for a particular academic period and living arrangement of the student. 529 plan qualified expenses for off-campus housing are not limited to rent. They can include groceries and utilities. For tax purposes, receipts for all qualified expenses must be kept.
Recent changes now allow expenses for fees, books, supplies, and equipment required for the designated beneficiary's participation in an apprenticeship program registered and certified with the Secretary of Labor under section 1 of the National Apprenticeship Act to be considered eligible expenses.
Qualified education expenses formerly did not include student loans and student loan interest. However, on December 12, 2019, the SECURE Act was signed into law, which allows for 529 withdrawals for "principal or interest on any qualified education loan", under certain conditions:
  • No more than $10,000 may be withdrawn for the purposes of paying a student loan
  • The $10,000 limit is a maximum lifetime limit per beneficiary and sibling
A distribution from a 529 plan that is not used for the above qualified educational expenses is subject to income tax and an additional 10% early-distribution penalty on the earnings portion of the distribution. The tax penalty is waived if any of the following conditions is satisfied:
  • The designated beneficiary dies, and the distribution goes to another beneficiary or to the estate of the designated beneficiary.
  • The designated beneficiary becomes disabled. People providing proof of being unable do any substantial gainful activity because of a physical or mental condition are considered disabled. A physician must determine that the individual's condition can be expected to result in death or continue indefinitely.
  • The designated beneficiary receives any of the following:
  • * a qualified scholarship excludable from gross income
  • * veterans' educational assistance
  • * employer-provided educational assistance
  • * any other nontaxable payments received for education expenses
  • The distribution is rolled over into an ABLE account whose beneficiary is either the original fund beneficiary or a qualified family member.