How New Tax Changes Promote 529 Investments

State-run 529 plans to help pay for education have always had tax advantages, but recent changes in federal tax law have made them even more attractive for many families. Here’s what you need to know to take full advantage of the latest rules.

529 Plans Can Now Be Used for K–12 Education

The 2017 Tax Cuts and Jobs Act (TCJA) brought several changes to 529 savings plans; the most common type of 529—the other main type, prepaid tuition plan, is offered by only a small number of states. In particular, the new law expanded 529 savings plans to cover K–12 education.

Previously, 529 plans, also referred to as qualified tuition programs (QTPs), were reserved for postsecondary education expenses. Those expenses included tuition and mandatory fees, room and board, textbooks, and other essentials. Withdrawals used for these qualified expenses were tax-free.

Under the TCJA, parents can now make tax-free withdrawals from a 529 account to pay for tuition at K–12 schools. However, those withdrawals are limited to $10,000 per year, while withdrawals for college costs can be whatever amount is needed to cover the qualified expenses. Anything beyond that is taxable.

529 Plans vs. Coverdell Education Savings Accounts

The K–12 change makes 529 plans similar to the less widely used Coverdell education savings accounts (ESAs). These accounts allow parents to save money toward college expenses and those related to elementary, middle, or high school education. One big difference, however, lies in how much parents can contribute to a 529 vs. a Coverdell ESA.

With a 529 plan, contribution limits are significantly more generous. Internal Revenue Service (IRS) rules allow parents to contribute as much to a plan as is needed to pay for the beneficiary’s qualified education expenses. Plans do set caps on how large the balance can grow—currently from about $235,000 to more than $550,000, depending on the state.

Another drawback of Coverdell ESAs is that not everyone can contribute to one. For 2022, only single filers with a modified adjusted gross income (MAGI) of less than $110,000 and married couples with incomes under $220,000 are eligible. No such income restriction exists for 529 plans. And finally, Coverdell contributions are not tax deductible, while 529 contributions earn a state tax deduction or credit in most states.

Transferring 529 Plan Funds to an ABLE Account

The 2017 tax law also allows account holders to transfer 529 assets to an Achieving a Better Life Experience (ABLE) account for the same beneficiary or another family member, as long as they don’t exceed the limits for annual deposits to an ABLE account ($16,000 in 2022). These tax-advantaged accounts can be used by people with disabilities without affecting their eligibility for certain benefits, such as Medicaid.

Paying Student Loans with a 529 Plan

The 2019 Setting Every Community Up for Retirement Enhancement (SECURE) Act, while primarily focused on retirement, also made several significant changes to the 529 rules.

For one, 529 proceeds can now be used to pay off some student loan debt for the account beneficiary or their siblings, up to a lifetime maximum of $10,000 per individual. Previously, student debt didn’t count as a qualified expense.

Using a 529 Plan for Apprenticeship Expenses

In another significant 2019 change, 529 funds can now be used to pay for the fees, books, supplies, and equipment required to participate in an apprenticeship program that’s registered and certified with the U.S. secretary of labor.

Coming Soon: A New Break for Grandparents

The Consolidated Appropriations Act (CAA) of 2021, passed in 2020, includes a provision called the FAFSA Simplification Act that is intended to streamline the Free Application for Federal Student Aid (FAFSA). That’s the form that most colleges, states, and other scholarship providers use to determine students’ financial aid packages. The simplification act was originally scheduled to go into effect on July 1, 2023.

Under the old rules, distributions from a grandparent-owned 529 plan were considered untaxed income to the student and had to be reported on the FAFSA. That income potentially reduced the student’s eligibility for financial aid.

Under the new rules, the FAFSA will no longer ask about such distributions. However, the U.S. Department of Education has delayed the implementation of this new rule, and it may not go into effect until the 2024–2025 school year. It’s also possible that it won’t go into effect at all—if Congress changes the tax laws before then.

What Hasn’t Changed

In addition to those recent changes, 529 plans retain all their earlier tax benefits (and potential penalties). To recap:

• State credits and deductions: More than 30 states offer a state tax deduction or credit if you live in that state and contribute to one of its 529 plans. Seven states—Arizona, Arkansas, Kansas, Minnesota, Missouri, Montana, and Pennsylvania—will even give you a tax break if you invest in another state’s plan. You can find information about your state’s tax breaks on the College Savings Plans Network website, affiliated with the National Association of State Treasurers.
• No federal deductions or credits: Unlike most states, the federal government provides no income tax deduction or credit for 529 contributions.
• Tax-deferred growth: The money in your 529 account will compound and grow tax-deferred, on both state and federal levels, until you withdraw it.
• Tax-free withdrawals: Any withdrawals you make will be state and federally tax-free if you use them for qualified education expenses. In the case of 529 savings plans, that includes tuition, room and board, and other required expenses. Prepaid tuition plans are limited to college tuition.
• Taxes on nonqualified withdrawals: If you make withdrawals for purposes other than qualified education expenses, you’ll owe income tax on the portion representing your investment gains but not on your contributions. You’ll also owe a 10% tax penalty in most cases.
• Changing the beneficiary: You can change the beneficiary on a 529 plan to another family member without incurring taxes.
• Federal gift tax implications: There’s no limit on how much you can contribute to a 529 plan each year, but any contributions over $17,000 ($16,000 in 2022) can trigger federal gift taxes. For example, if you have three children with three 529 savings plans, you could give each of them $17,000 without owing gift tax. Married couples filing a joint return can double that amount per child. Grandparents and other family members can also contribute that same amount. To contribute even more without triggering the gift tax, you can also front-load the 529 by making up to five years worth of contributions ($85,000) all at once if you can afford to. You won’t be able to make any additional contributions to the plan until five years have passed, but the money will have more time to benefit from compounding, potentially growing faster.