529 Plan Tax Benefits

Everyone has hopes and dreams for their children. Maybe they become a famous writer, a heart surgeon, or a successful entrepreneur. In many cases, parents hope their children will reach their dreams by attending a college, university, or training program that will boost them to the next level of success.

Unfortunately, however, the cost of higher education in the U.S. has increased exponentially in the last decade. In fact, the cost of education has outpaced the inflation rate by 179.2% in the last 20 years for an average annual increase of 9.0%. The government has offered a few different ways for citizens to handle the high cost of education in the United States. Among these is the 529 investment account, which allows parents, grandparents, or general well-wishers to invest their money into an account with certain tax advantages.

A 529 plan works similar to a Roth IRA or 401(k), in which contributions are not exempt from federal income taxes when contributions are made.

This means that the contributions made to a 529 plan are taxed at the federal level without any federal income tax deduction. For example, if you contribute $5,000 to a 529 plan, then you must first pay taxes on the contribution before you invest it.

Instead, they are allowed to grow and be withdrawn tax-free as long as the money is being used for qualified education expenses. This is significant because you don’t need to worry about paying capital gains tax on the account’s growth or income tax from withdrawals on a federal level.

Let’s take a look at how these benefits work in practice. In this scenario, Person A invests in a normal account without any special tax treatment, and Person B invests in a 529 account. For this example, we assume that the federal capital gains tax (CGT) rate for both investors is 15%. Both investors place $15,000 into their account, which after five years is worth $50,000.

The person who didn’t use a 529 plan will need to pay capital gains tax on their growth, equaling $5,250. Person B, who used a 592 investment account, will receive the entire $50,000. This is because although the investment grew, they paid $0 in taxes on the gains from the investment on a federal level.

Furthermore, say that the 529 investor is holding stocks that pay a dividend or an income. In normal circumstances, this dividend would be taxed at the federal level; however, with a 592 plan, that income is tax-free.

Looking for the right investment and tax strategy? These are some of the recommended investment advisors that can help with both.

The United States is famous for its federal system that allows states to greatly determine their own economic and tax policy. In the world of 529 investment accounts, different states have different rules in terms of tax exemptions.

Unlike the federal level where contributions are taxed before they enter the account, in some states, they are completely exempt from all state taxation whatsoever through a state income tax deduction. However, this differs greatly from state to state.

In North Dakota, for instance, there is a $5,000 state tax deduction for a single filer and a $10,000 deduction for joint filers. This number jumps to $10,000 for a single filer in Oklahoma and $20,000 for a joint filer. In New Mexico, they let you deduct the full amount of the contribution. Thus, if you contribute $8,000, you can deduct $8,000 from state income taxes in New Mexico.

* Source

A gift tax is a federal tax that is levied on a transfer of assets or property from one person to another. The receiving party is receiving the assets for less than or equal to the current value. The gift tax is applied regardless of whether the donor intends to send the gift. Gift taxes are usually declared on IRS 709 Form.

The IRS generally considers 529 college savings as a gift from one entity or another. This means that in some cases, it falls under the federal gifting rules. This comes with both advantages and disadvantages related to the federal annual gift tax income exclusion. Currently, the federal gift tax exclusion stands at $16,000 per individual being gifted. This $16,000 exemption is applied to each person sending a gift.

For example, say you have three kids and you are married. This means that for each kid, you and your spouse can give $16,000 each, or $32,000 per child together. This means that you and your wife can contribute $96,000 that is exempted from any kind of federal gift tax.

Fortunately, those transferring a large amount of wealth at once have a bit of a tax advantage. The federal government allows you to average the initial gift amount over five years and use your annual gift tax exclusion for the five-year average.

Say, for example, a grandparent dies, and the remaining grandparent would like to transfer a substantial sum of money to the grandchildren’s 529 savings account. For simplicity purposes, let’s say that the amount being given is $75,000.

The federal government allows you to take the $75,000 and divide it by five years. This equation can be explained in the table below.

In the first example, the grandparent plans on transferring the $75,000 directly to the grandchild. They have an annual gift tax exclusion of $16,000. They are then liable to pay gift tax on the remaining $59,000.

In the second scenario, the grandparent allocates the entire $75,000 gift to a 529 plan. They can now divide that number by five for an average annual gift of $15,000. This means that when transferring the gift to the 529 accounts, they are paying $0 in gift tax because the $15,000 per year is smaller than the annual exclusion of $16,000. In fact, in this scenario, they can contribute another $1,000 per year as a gift if they choose to do so.

A 529 plan can indeed impact financial aid, but the impact is limited. This impact typically applies if the 529 account is owned by a parent or custodian of the beneficiary. Assets in a 529 account owned by a parent are typically counted as the parent’s assets on their FAFSA applications.

The first $10,000 (approximately) a parent contributes is protected by the Asset Protection Allowance. However, past that $10,000, the student’s potential financial aid will gradually reduce. Fortunately, the federal government caps this reduction at 5.64% of assets.

Yes, you are available to open a 529 account in multiple states. Though you may not have much use for multiple 529 accounts, you can open accounts in several states at once.

Yes, you can use a 529 to pay for college in any state. However, rolling over a 529 plan into a new state may come with different state tax requirements, so keep this in mind before acting too quickly.

The Consolidated Appropriations Act of 2021 is one example of recent tax changes that should promote 529 investments by treating non-custodial accounts differently than before. This should have an impact on non-parent-owned 529 accounts when assessing financial aid eligibility. However, this won’t come into effect until the 2024 – 2025 school year. This gives ample time to speak to a qualified tax advisor if this affects you.