State-run 529 plans 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 new rules.
- Federal tax laws passed in 2017 and 2019 added several new tax benefits to 529 plans.
- 529 plans can now be used for K-12 expenses, not just those for college and other post-secondary education.
- 529 plans can also be used to pay off a portion of student loan debt as well as for vocational school expenses.
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 plans, are 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 were reserved for post-secondary education expenses. Those expenses included tuition and fees, room and board, textbooks, and other essentials. Withdrawals used for these qualified expenses were tax-free.
Under the new tax law, parents now make tax-free withdrawals from a 529 account to pay for tuition at K-12 schools, as well. However, those withdrawals are limited to $10,000 per year, while withdrawals for college costs can be whatever amount is needed to cover 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 (ESA). These accounts allow parents to save money toward both 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 versus a Coverdell ESA.
A 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, contribution limits are significantly more generous. 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 $235,000 to more than $500,000, depending on the state.
Another drawback of Coverdell ESAs is that not everyone can contribute to one. For 2019, only single filers with a modified adjusted gross income 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 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 ($15,000 in 2020) . These tax-advantaged accounts can be used by individuals 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 major 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.
529 proceeds can now be used to pay off a portion of student loan debt for both the account's beneficiary and their siblings.
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 Secretary of Labor.
What Hasn't Changed
In addition to these recent changes, 529 plans retain all of 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 Saving 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 grow and compound tax-deferred, on both the state and federal level, until you withdraw it.
- Tax-free withdrawals. Any withdrawals you make will be 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 non-qualified withdrawals. If you make withdrawals for purposes other than qualified education expenses, you'll owe income tax on the portion that represents your investment gains, but not 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. While there's no limit on how much you're allowed to contribute to a 529 plan each year, any contributions over $15,000 can trigger federal gift taxes. If you have three children with three 529 savings plans, for example, you could give each of them $15,000 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 ($75,000) 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 compound interest and potentially grow faster.