May 29 is National College Savings Day, a day highlighting the 529 plans that help families save for college (it's 5/29, after all). In celebration, a number of states are offering prizes and contents to encourage new accounts. For example, Nebraska's Nest 529 plan offered $100 bonuses to the first 100 new accounts opened by the end of May, and the California ScholarShare 529 plan is offering $50 for new accounts opened through June 1.
Savers should know that the new 2017 tax legislation brought some big changes for taxpayers, including updates to the rules for 529 savings plans for college. These plans, designed to help parents save for their children’s college expenses on a tax-advantaged basis, have been expanded to cover savings for K-12 education. According to a Wall Street Journal report, that change and fallout from other tax shifts, such as limits on deductions for state and local taxes, mean that contributions to these plans may soon see an uptick.
That would be a further uptick; these plans had been growing before the new law. Through the third quarter of 2017, 529 plan assets rose to $282 billion, up from $276 billion the previous quarter. Here are the details on how the tax changes play out for parents and others paying for education through 529 plans.
The Tax Deduction Factor
Here's why new limits on state and local tax (SALT) deductions might boost 529 plans: Beginning in 2018 SALT deductions will be capped at $10,000. For parents living in one of the roughly three dozen states that offer a state income tax deduction or credit for 529 plan contributions made to that state's plan, those tax breaks can be a way to counter the new SALT deduction limit and find a different route to minimize tax liability.
If you’re a 529 plan parent or are thinking of opening one of these accounts, there may be more incentive to do so now than ever. Just be sure you're in a state that offers these deductions and that you choose the right plan. Click here to look up your state on Savingforcollege.com's comparison chart.
More Options for 529 Savings Plans
Previously, 529 plans were reserved for post-secondary education expenses. Those expenses include tuition and fees, room and board and computer software or equipment deemed necessary to the student. The Internal Revenue Service (IRS) restricted the use of 529 plan monies to colleges and universities that were eligible to participate in federal student aid programs. Withdrawals used for these qualified expenses were tax free.
Under the new tax law, parents can also withdraw savings tax free from a 529 account to pay for tuition at private or religious schools for K-12 education. Unlike for college, those withdrawals are limited to $10,000 per year.
In that respect the change makes 529 plans similar to the less widely used Coverdell Education Savings Account (ESA). These accounts allowed parents to save money toward both college expenses and costs related to elementary, middle or high school education. One big difference, however, lies in how much parents can save in a 529 versus a Coverdell ESA.
The Coverdell account limits parents to saving $2,000 per year for their child or another qualified beneficiary up until the recipient reaches age 18. With a 529 plan the contribution limits are significantly more generous. The IRS allows parents to contribute as much to a plan as is needed to pay for their beneficiary’s qualified education expenses. The total balance permitted is determined by the plan itself, based on the average cost of attendance in the state sponsoring the plan (see "You Can't Deposit an Unlimited Amount," below).
Another important caveat of Coverdell ESAs is that not everyone can contribute to one of these plans. For 2018 contributions are allowed by single filers with a modified adjusted gross income of less than $110,000 and less than $220,000 for married couples filing a joint return. No such income restriction exists for 529 plans. While initial tax reform proposals would have eliminated the Coverdell ESA entirely, these plans continue to be a college savings option for eligible parents.
The new tax law also allows depositors to transfer 529 assets to ABLE accounts, as long as they follow the limits for annual deposits to an ABLE. These tax-advantaged accounts can be used by disabled savers without affecting their eligibility for key benefits, such as Medicaid (some total-balance limits apply, so check with a financial advisor). Through the third quarter of 2017, 529 ABLE account assets rose to $48.5 million across 13,190 accounts.
Front-Loading 529 Plans and the Gift Tax
While the IRS doesn’t specify a set dollar amount for 529 plan contributions, there’s one important number parents need to be aware of: the gift tax exclusion limit. For 2018 the gift tax exclusion limit (meaning the amount you can give an individual without triggering the gift tax) is $15,000. If you have three children with three 529 savings plans, for example, you could give each of them $15,000 without paying 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. With a Coverdell ESA, by comparison, the total annual contribution limit is capped at $2,000, regardless of who makes the contributions.
There is one way to give even more without triggering the gift tax: Contributors can front-load a child’s 529 by making up to five years’ worth of contributions ($75,000) all at once. They then won't be able to make any new contributions to the plan until five years have passed, but it means the account has more years to benefit from compound interest on the savings and potentially grow the investment faster.
Another way to circumvent the gift tax is by making tuition payments directly to the child’s school. As long as the student doesn’t receive the money personally, it doesn't count as a gift. Of course, by making payments directly rather than saving the money in a 529, you sacrifice any potential returns it would have earned. (For more, see Why You Should Front-Load Your 529 Plan.)
You Can’t Deposit an Unlimited Amount
Various plans and states limit how much money can be in 529 plans for a single beneficiary. For example, the CollegeCounts 529 Fund in Alabama limits contributions to the point that “all account balances in Alabama plans for the same beneficiary reach $400,000.” The Ivy InvestEd 529 Plan in Arizona sets $453,000 as the limit, and two New York State plans, the 529 Advisor-Guided College Savings Plan and the 529 College Savings Program – Direct Plan, limit it to $520,000. Click here for Savingforcollege.com's list. Note that if your child has more than one 529 plan from different sources, such as one from a grandparent and one from a parent, the total of all plans has to be under the limit. (For more, see Top Companies That Manage 529 Plans.)
Non-Education Withdrawals Still Result in a Tax Penalty
The IRS has always been firm about what 529 plan funds can be used for. Withdrawals made for expenses other than college education or in excess of what’s needed to pay for education expenses have been subject to federal income tax, along with a 10% early withdrawal penalty. That hasn’t changed under the new tax law.
If your child doesn’t use all of the 529 plan money or decides not to go to college, you may be tempted to withdraw your savings and take the tax hit. A better solution, however, is to transfer the money to another beneficiary, which could include another child, family member, your spouse or even yourself. This allows your savings to continue growing tax free. Money from a 529 can also be transferred to an ABLE account for the same beneficiary or another member of the family.
The Bottom Line
If you have yet to open a 529 savings plan because your children are young, the new tax legislation offers significant motivation to do so. Remember to compare your plan options carefully, as you’re not required to save in your home state’s plan. Just be aware that if your state offers a state income tax deduction or credit for making contributions to a 529 account, that probably only applies to an in-state plan. And, of course, you need to live in a state that has state income tax.