The 529 college savings plans are one of the strongest tools for college savings. These plans allow you to make significant contributions that grow tax-free as long as you follow all applicable tax rules and regulations. Funds in a 529 plan can be used to pay for any college-related expenses, including tuition, fees, room and board, books, and computers used in school. The funds can be used for undergraduate or graduate programs.
What We Like About 529 Plans
1. Tax-free earnings if used for qualified expenses.
2. Broad definition of qualified expenses.
3. High contribution limits.
4. Can start saving decades before the beneficiaries reach school.
5. Potential tax deductions on state contributions.
What We Don’t Like About 529 Plans
1. Penalties on non-qualified expenses.
2. Gift tax implications on large contributions.
3. Market return unpredictability.
4. Rising tuition that outpaces market growth.
Maximum Contribution Limits
The Internal Revenue Service sets contribution limits for 529 plans not to exceed what is necessary to pay for the qualified education expenses of the beneficiary. As state-sponsored programs, each state sets limits on how much can be accumulated in their 529 accounts. Most limits are based on the expected total cost of higher education at qualified institutions.
Contributions can be made to the account until the beneficiary reaches $520,000 in New York. The account can continue to grow after reaching the maximum, but no new contributions will be allowed. Other states have similar limits. California sets the maximum at $529,000 and Michigan allows up to $500,000.
Gift Tax Issues
You can save a significant amount in a 529 plan, but adding money too quickly can create problems. Gift tax limits set how much money can be transferred from one person to another before the IRS intervenes. American citizen couples can gift each other unlimited amounts, but contributions to a 529 plan for a child, grandchild, or other individual can be considered gifts, and these gifts can impact current or future taxes.
Annual Gift Tax Exclusion
Individuals are allowed to gift a certain amount each year before triggering the gift tax. This is known as the annual exclusion and is set at $15,000 for 2021, increasing to $16,000 in 2022. The tax applies to the person giving the gift, not the recipient. Couples filing jointly can give up to $32,000 in 2022 without triggering the gift tax.
Gifting Above the Limit
You are free to gift an amount greater than the annual exclusion ($15,000 or $16,000) to the same person in the same year, but you must report the gift to the IRS on Form 709. You may not necessarily have to pay taxes on the gift as it could be covered by the lifetime gift tax exemption, but you must report it nonetheless.
Five-Year Election
The IRS allows contributions to 529 plans for five years in one lump sum while potentially avoiding gift tax consequences. You can contribute $75,000 in 2021 or $80,000 in 2022 (or $150,000 or $160,000 for married couples) to a beneficiary’s 529 account in one payment, but your Form 709 must reflect your choice to elect the five-year option.
This is a powerful way to jumpstart a savings plan, but its rules can be complex. It can be easy to make “overlap” gifts by accident and give too much. Making additional gifts during the five-year election period could trigger tax consequences.
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The person who made the contribution during that five-year period has passed away, and the heirs may have to include part of the contribution for estate tax purposes.
Direct Payments
Payments made outside of a 529 plan directly to a higher education institution for tuition costs are generally not subject to gift taxes. This is not very helpful if you are saving money for a newborn, but it can be beneficial for parents or grandparents who wish to help while the child is in school. However, this strategy is not ideal as it is only useful for paying tuition fees.
Money designated for housing, food, or other expenses may be treated as a gift. You should also consider that it may affect the student’s ability to receive financial aid.
Deduction Limits
Another limit worth noting is how much you can benefit from tax incentives in the current year. Filers may be eligible for a state income tax deduction on contributions to 529 plans in some states. The availability of state income tax deductions varies by state, and each state may have different rules and deduction limits.
The primary goal of a 529 account is to build assets for future expenses, so you may not care about the limits. However, it is always good to know how much you benefit from making contributions, and you do not want to claim a deduction you are not entitled to.
For example, taxpayers in New York State using the New York 529 plan may have the right to deduct up to $5,000 (or $10,000 for married couples filing jointly) on their state tax returns. Illinois doubles those amounts (married couples can deduct up to $20,000), and some states allow a full deduction of your contributions.
Note: Some states base the limit on the taxpayer claiming the deduction, while others apply separate limits for each beneficiary. Contributions for multiple beneficiaries can provide a higher total deduction.
Contributions to 529 plans that exceed the gift tax exclusion may not qualify for federal income tax deduction, but that does not mean federal benefits do not exist. Earnings inside a 529 account are not taxed annually, and all earnings can potentially come out without paying taxes if the funds are used for qualified higher education expenses. Of course, income tax and penalty taxes may be imposed on earnings if the funds are not used for qualified expenses.
Consult a Tax Professional
States often make changes to 529 plan rules. Consult a local tax advisor and financial planner familiar with the rules in your state before making significant decisions or taking financial actions. It is always best to prevent problems before they occur by consulting an expert.
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Sources:
1. NY’S 529 College Savings Plan. “529 Basics.”
2. Michigan Legislature. “Michigan Education Savings Program Act,” Pages 4-5.
3. ScholarShare529. “Frequently Asked Questions.”
4. Internal Revenue Service. “IRS Provides Tax Inflation Adjustments for Tax Year 2022.”
5. Internal Revenue Service. “Frequently Asked Questions on Gift Taxes.”
6. Internal Revenue Service. “Instructions for Form 709 (2021).”
7. New York’s 529 College Savings Program. “Direct Plan Tax Benefits.”
8. Illinois Revenue. “Do Contributions to IRC Section 529 College Savings and Tuition Programs Qualify as a Deduction?”
9. Internal Revenue Service. “Qualified Education Expenses.”
Source: https://www.thebalancemoney.com/529-limits-contributions-balances-taxes-4138359
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