The unique benefits of 529 college savings plans

To start with the basics, a 529 plan is legally known as a “qualified tuition plan.” It is a tax-advantaged plan that has as its primary purpose to encourage savings for the cost of a college education. All states (other than Wyoming), as well as the District of Columbia, offer at least one type of 529 plan. Account owners of 529 plans do not have to be a resident of a state to establish a 529 plan in that state; they are free to choose which state best meets their particular situation. Once a 529 plan is opened, the source of contributions is not limited to the owner; anyone can contribute to it.

Distributions from a plan are tax-free to the distributee if they are for qualified higher education expenses. The plan owner names a beneficiary at the time the plan is set up. Each 529 account has one owner and one beneficiary. The owner and the beneficiary are generally allowed to be the same person. Normally, the owner is allowed to name a successor who will become the owner upon the death of the original owner. A few states may prohibit the owner and beneficiary from being the same person or disallow a successor owner to be named.

The owner is allowed to change beneficiaries without income tax consequences as long as the new beneficiary is a member of the family of the old beneficiary.¹ The IRS provides a broad definition of who is a related family member of the current beneficiary. For example, along with siblings, this would include first cousins and nephews and nieces.²

Contributions to a 529 plan

Contributions to a 529 plan are made with after-tax dollars. Consequently, there are no income tax ramifications when contributions are made. All earnings, such as capital gains, dividends, or interest generated within the plan, are allowed to grow tax-free. There is no annual limit on contributions. Contributions to a 529 plan are considered gifts, however, and are subject to the gift tax provisions. These include an annual gift tax exclusion per donee that in 2023 is $17,000 ($34,000 if gift splitting).³ Moreover, the plan owner can make an election to use five annual exclusions in one year without triggering a taxable gift. If the current annual exclusion of $17,000 remained constant over the five-year period, $85,000 ($170,000 with gift splitting) could be contributed in a single year.⁴ The annual gift tax exclusion would no longer be available for the following four years if this election were made.

In addition, each state imposes an aggregate, albeit generous, maximum contribution balance per beneficiary. These limits currently range from $235,000 to $550,000. The aggregate contribution limit is intended to be sufficient to fund an expensive four-year college as well as graduate school in the state where the 529 plan is set up. Once the account reaches the limit, no further contributions are accepted. However, earnings from the investments are allowed to grow beyond these limits. If the account balance falls below the state limit because of, for example, a downturn in the stock market, further contributions are allowed.⁵ The maximum limit is per state, so nothing prevents another 529 plan from being set up for the same beneficiary in another state. However, contributions to a qualified tuition plan on behalf of any beneficiary are limited to the amount necessary to provide for the beneficiary’s qualified higher education expenses.

Qualified higher education expenses

A beneficiary needs to be enrolled at an eligible post-secondary educational institution for his or her college expenses to be qualified higher education expenses. An eligible institution is one described in Section 481 of the Higher Education Act of 1965 and eligible to participate in a student loan program under Title IV of the act.⁶

Qualified higher education expenses are tuition and fees as well as books, supplies, and equipment required for enrollment.⁷ Expenses for room and board are allowed only if the student is enrolled at least half-time.⁸ Room and board costs are qualified only to the extent that they are not more than the greater of the amount that the school actually charges for living on campus or the allowance for room and board included in the cost of attendance (for federal financial aid purposes) as determined by the school for the period.⁹ Additionally, the cost of computers, computer software, peripheral equipment, or internet access is allowed as long as they are used primarily by the beneficiary during the years he or she is enrolled at an eligible institution.¹⁰

The law known as the Tax Cuts and Jobs Act (TCJA)¹¹ expanded the definition of “qualified higher education expenses.” Under the TCJA, qualified expenses now include up to $10,000 per year for K-12 tuition for any public, private, or religious school.12 Not all states recognize the tax-free distribution for K-12 schools, so the earnings portion of the distribution for those states would be taxed at the state level and any state tax breaks would be subject to recapture.

The Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019¹³ further expanded the definition of qualified 529 plan educational expenses in two ways: Up to a maximum lifetime limit of $10,000 per beneficiary may be used to pay off student loans. Any interest, however, associated with the payment cannot be deducted on the tax return.14 Also, 529 distributions can be used for textbooks, fees, and equipment related to apprenticeship programs.¹⁵

Determining the adjusted qualified education expenses

The beneficiary of a 529 plan receives a Form 1099-Q, Payments From Qualified Education Programs (Under Sections 529 and 530), by Jan. 31 of the following year. Box 1 of the form indicates the gross distribution amount for the year. Box 2 shows the earnings part of the gross distribution. Box 3 shows the basis portion of the gross distribution reported in box 1. As long as the beneficiary’s adjusted qualified education expenses are greater than the gross distribution amount, the distributee does not have any taxable income. The distributee is the designated beneficiary or the account owner, if the account owner receives or is treated as receiving a distribution from the 529 plan.

To determine the adjusted qualified education expenses, the education expenses that are treated as qualified higher education expenses, however, need to be reduced by any tax-free education assistance the beneficiary receives. Tax-free education assistance includes the tax-free portion of scholarships and fellowships, Veterans’ educational assistance, the tax-free part of Pell grants, any employer-provided educational assistance, and any other nontaxable payments (other than gifts or inheritances) received as educational assistance. Also, the qualified higher education expenses will have to be reduced by any educational expenses incurred by the beneficiary that were taken into account in determining the amount of the American opportunity tax credit or the lifetime learning credit. The qualified higher education expenses, minus any tax-free education assistance and the expenses used to calculate either education credit, equals the adjusted qualified education expenses, which are the amount the taxpayer may count as a tax-free distribution.¹⁶

Example 1: S, an undergraduate at a local college and the beneficiary of a 529 plan, paid tuition and fees to the college of $10,000. From his university, he received a nontaxable tuition scholarship of $2,500. Additionally, his parents claimed $4,000 of tuition costs that they paid on S’s behalf to receive an American opportunity tax credit of $2,500.

S’s adjusted qualified education expenses would be calculated as shown in the chart “S’s Adjusted Qualified Education Expenses,” below.

Calculating any taxable portion of a distribution

The Sec. 72 annuity rules dictate the portion of a distribution, if any, that is taxable.17 If the adjusted qualified education expenses are less than the gross distribution amount of box 1 of the Form 1099-Q, and box 2 of the Form 1099-Q indicates that earnings have been generated in the 529 plan, then the beneficiary has taxable income. To calculate taxable income, the adjusted qualified education expenses amount is divided by the box 1 gross distribution. This fraction is then multiplied by the earnings amount in box 2. This will equal the tax-free earnings amount. As a second step, the tax-free earnings amount is subtracted from the earnings amount (box 2) to calculate the taxable income. The taxpayer’s taxable earnings are illustrated by the following example:

Example 2: J in the current year has adjusted qualified education expenses of $7,000. Her Form 1099-Q, box 1, indicates a distribution of $8,000 and, in box 2, earnings of $3,000. Her taxable income would be calculated as follows:

1. ($7,000 adjusted qualified education expenses ÷ $8,000 distribution) × $3,000 earnings = $2,625 (tax-free earnings).
2. $3,000 (earnings) – $2,625 (tax-free earnings) = $375 (taxable earnings).

Additional 10% penalty tax on ordinary income

Generally, on the distribution portion that is classified as taxable income, there is a 10% penalty tax. In Example 2, in addition to $375 being taxed as ordinary income, the beneficiary will be subject to a penalty tax of $37.50 ($375 × 10%). The penalty tax, however, does not apply to the extent the qualified higher education expenses were reduced because of tax-free education assistance and education expenses used to calculate either education credit.18

Most states offer tax benefits for contributions to 529 plans

Tax benefits offered by states may be broadly categorized as follows:

• States that offer a deductible contribution only for in-state plans;
• States that offer a tax credit, instead of a tax deduction, for in-state plans; and
• States that offer a deductible contribution regardless of which state administers the plan (so-called tax parity states).

A few states with an income tax offer no tax deduction, even for in-state plans, and it is not possible to receive a tax benefit for states without an income tax.

Twenty-four states plus the District of Columbia currently limit a deductible contribution to only in-state plans. That is, a deduction is available to residents of these states only if they select the 529 plan offered by their home state. They are: Alabama; Colorado; Connecticut; Georgia; Idaho; Illinois; Iowa; Louisiana; Maryland; Massachusetts; Michigan; Mississippi; Nebraska; New Jersey; New Mexico; New York; North Dakota; Oklahoma; Rhode Island; South Carolina; Utah; Virginia; West Virginia; and Wisconsin. Three states offer a tax credit, instead of a tax deduction, for in-state plans (Indiana, Oregon, and Vermont). Nine states offer tax parity (Arizona, Arkansas, Kansas, Maine, Minnesota, Missouri, Montana, Ohio, and Pennsylvania). Five states offer no 529 tax deduction, even for an in-state plan: California, Delaware, Hawaii, Kentucky, and North Carolina. Finally, eight states currently do not have a state income tax: Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, and Washington.19 Wyoming currently does not offer a 529 plan.

Residents of the states with tax parity should not only identify the state with the best state tax benefits but should also consider whether there is an adequate selection of investment choices and the track record of these investment choices. Residents of states with no state income tax or who live in a state without a 529 tax benefit should choose the state plan based strictly on its investment merits.

Residents of states that offer only in-state tax benefits need to weigh whether the tax benefits of their state outweigh those of another state that might have superior investment choices. Morningstar, a major investment research company, regularly evaluates all but the smallest 529 plans based on their investment merits. The better plans, based on Morningstar’s evaluation, receive either a gold, silver, or bronze designation.²⁰

Rollover of one 529 plan to another 529 plan

It might make sense to roll one 529 plan to a different plan if the owner wants to move the money to a different family member under a different plan or if the owner identifies a plan with superior investment options. A rollover from one 529 plan to another 529 plan does not trigger income tax as long as it is for the same beneficiary or for the benefit of a member of the beneficiary’s family.²¹

Example 3: K recently completed her college education, which was primarily funded through her 529 plan. She still has $20,000 remaining in her 529 plan. She has a younger brother, R, who has yet to begin college and who also has a 529 plan. Their father, the owner of the plan, rolls over the remaining balance in K’s plan into R’s 529 plan without triggering taxable income.

Owners are, however, allowed to do a rollover only once during a 12-month period for the same beneficiary.²² Also, the rollover must be completed within 60 days of the date of a distribution.²³

Generally, there are also no gift tax consequences of a rollover from one 529 plan to another, as long as there is no change in beneficiary or the change in beneficiaries is for a member of the beneficiary’s family.²⁴ However, the gift tax applies if the change in beneficiary is to one or more generations below the original beneficiary (e.g., from a child to a grandchild).²⁵

529 plans owned by a decedent are generally not included in the decedent’s estate

Normally, if a decedent retains control over an asset at the time of death, the asset is included in the decedent’s estate. To remove the asset from the estate, it is usually necessary to irrevocably transfer ownership of the asset to another party. In contrast, 529 plans are not included in the owner’s estate, even though the owner is able to control the beneficiaries, investment options, and timing of the distributions.²⁶

There is an important exception, however, to 529 plans’ not being included in the owner’s estate. Recall that up to five gift tax annual exclusion amounts may be made in the first of five calendar years without triggering a taxable gift. However, if the owner dies before the end of the five-year period, a portion of the contribution is brought back into the decedent’s estate.²⁷

Example 4: An owner of a 529 plan makes a one-time contribution of $85,000 (five years × $17,000 annual gift tax exclusion (assuming the exclusion amount remained constant)) to take advantage of the five-year gift tax exclusion rule. She dies at the end of year 1. The contributions applicable for years 2-5, or $68,000 (4/5 × $85,000), would be included in her estate.

The Roth IRA as an alternative to the 529 plan

With a Roth IRA, like a 529 plan, contributions are made with after-tax dollars, and distributions are tax-free as long as certain conditions are met. Specifically, in the case of a Roth IRA, if the account owner is as least 59½ years of age and has owned the Roth IRA for at least five years, the distributions are tax-free.²⁸ But if the account owner using Roth funds to pay for an individual’s education expenses is under 59½ years old, the distribution of the earnings portion will be taxable.

This is one of the ways that Roth IRAs are generally less desirable than 529 plans as educational savings vehicles. Another is, unlike a 529 plan, the Roth IRA has strict contribution and income limitations. The maximum allowable contribution for a Roth IRA is $6,500 ($7,500 if age 50 or older) in tax year 2023.²⁹ The modified adjusted gross income (MAGI) phaseout ranges for direct contributions to a Roth IRA in 2023 are $218,000 to $228,000 for married filing jointly filers and $138,000 to $153,000 for single and head-of-household filers.³⁰ But Roth IRAs also can have certain advantages for educational planning. Unlike a 529 plan, where a beneficiary can only be switched to a family member, with a Roth IRA there is total flexibility in determining how the funds in the account are used if they are not needed for the intended beneficiary’s education expenses. See the chart “529 Plans and Roth IRAs Compared,” below, for a list of relative advantages and disadvantages.

While primarily designed as a retirement vehicle, a Roth IRA might be used to finance education expenses instead of a 529 plan if there is considerable doubt about whether funds in a 529 plan will ever be used for qualified education purposes. Relying on a Roth can help to avoid a situation where a 529 plan has a large amount of leftover funds that are not needed for educational purposes and the only option is taking a nonqualified distribution from the 529 plan with a 10% penalty on investment earnings.

For example, using a Roth IRA might make sense where the taxpayer only has one child and no other close relatives and there is considerable doubt that the child will choose to receive additional education beyond high school. Even under these circumstances, however, the only taxpayers who should consider using a Roth IRA for education purposes are generally those who are confident they will have sufficient resources other than a Roth IRA to fund their retirement. These resources might include employment retirement plans, taxable accounts, and traditional IRAs.

Recently, Congress took steps to mitigate the problem of having leftover funds in a 529 plan that will likely never be used for educational purposes. Beginning in 2024, the SECURE 2.0 Act of 2022 allows for an opportunity to make direct tax-free rollovers from a 529 plan to a Roth IRA.³¹

The opportunity to roll over 529 funds to a Roth IRA, however, does have significant restrictions. The 529 account must have been open for more than 15 years. The rollover must be from the beneficiary of the 529 plan (not the account owner) to a Roth IRA held in the beneficiary’s name. Any contributions and earnings from those contributions made in the last five years are not allowed to be rolled over. The total lifetime rollover amount must be no more than $35,000 to the beneficiary. The rollover amount is subject to the annual Roth contribution limit ($6,500 for 2023), but there is no MAGI constraint.

Taxability of Roth IRA distributions

In general, Roth IRA distributions for educational expenses are not tax-free, which is a key difference from 529 plans, as previously noted. But distributions from a Roth IRA are deemed to be withdrawn first from a taxpayer’s contributions, so there is no tax as long as distributions do not exceed the amount of the contributions.³²

Example 5: A taxpayer has contributed $15,000 to a Roth IRA, and it currently has a fair market value of $25,000. The taxpayer decides to use her Roth IRA to help fund her son’s education. As long as she does not withdraw more than $15,000 from the Roth IRA, it will be treated as a tax-free return of capital.

Withdrawals of more than the taxpayer’s contributions are taxed as ordinary income, with limited exceptions, unless the five-year ownership period and 59½ age requirement are met. This would include payments toward education expenses. The additional 10% premature withdrawal penalty does not apply, however, as long as the withdrawals are used for qualified higher education expenses.³³

Student financial aid considerations

If the student is likely to apply for financial aid, the taxpayer should be aware of how either a 529 plan or a Roth IRA would impact financial aid eligibility. Eligibility for financial aid requires that a student complete the Free Application for Federal Student Aid (FAFSA). If a 529 plan is owned by the student’s parent or the student, it is considered an asset on the FAFSA, except for the first $10,000 in the 529 plan. Any amount above $10,000 in the 529 plan will reduce aid eligibility by as much as 5.64% of the plan’s value. On the other hand, qualified distributions from a 529 plan owned by a parent or student are not counted in determining aid eligibility.

Because the funds in a Roth IRA are considered to be a retirement asset, they are not included in the FAFSA. However, all distributions from a Roth IRA, whether they are taxable or tax-free, count as either taxable or untaxed income on the FAFSA.³⁴

A unique opportunity

The 529 plan offers the taxpayer a unique opportunity to pay for education costs. As with a Roth IRA, 529 plan contributions are made with after-tax dollars, and distributions are tax-free, subject to certain restrictions. Recently, the definition of “qualified higher education expenses” has been expanded to include up to $10,000 annually for K-12 tuition and up to a maximum lifetime limit of $10,000 per beneficiary to pay off student loans.

Virtually all states offer a 529 plan, and the 529 plan owner is free to choose among any state plans. However, about half the states limit a state tax benefit to only in-state plans.

With some restrictions, the owner is allowed to change beneficiaries without tax consequences, as long as the new beneficiary is a member of the same family.

Normally, if a decedent was able to exercise control of an asset, for example, the right to change beneficiaries, the asset is included in the decedent’s estate. In contrast, a 529 plan is not included in the owner’s estate upon his or her death.

If there is considerable doubt about whether a 529 plan will ever be able to be used for education purposes, the taxpayer may want to alternatively consider a Roth IRA instead because of its greater flexibility in how the proceeds may be used. Generally, however, the Roth IRA should be used to finance a child’s education only if the taxpayer has sufficient alternative resources to finance retirement.

Footnotes

¹Sec. 529(c)(3)(C)(ii).

²See IRS Publication 970, Tax Benefits for Education, pp. 53—54 (2022), for a complete list of eligible related family members.

³Sec. 2503(b) and Rev. Proc. 2022-38.

⁴Sec. 529(c)(2)(B).

⁵Flynn, “Maximum 529 Plan Contribution Limits by State,” Saving for College (Jan. 25, 2023).

⁶Higher Education Act of 1965, P.L. 89–329; see Sec. 529(e)(5) and IRS webpage, “What Is an Eligible Educational Institution?“

⁷Sec. 529(e)(3)(A).

⁸Sec. 529(e)(3)(B).

⁹Sec. 529(e)(3)(B)(ii)(I); IRS Publication 970, Tax Benefits for Education, pp. 50—51 (2022).

¹⁰Sec. 529(e)(3)(A)(iii).

¹¹The law known as the Tax Cuts and Jobs Act, P.L. 115-97.

¹²Secs. 529(e)(3) and 529(c)(7).

¹³Division O of the Further Consolidated Appropriations Act, 2020, P.L. 116-94.

¹⁴Sec. 529(c)(9); Sec. 221(e).

¹⁵Sec. 529(c)(8).

¹⁶Sec. 529(c)(3)(B) and IRS Publication 970, Tax Benefits for Education, pp. 51–52 (2022).

¹⁷Sec. 529(c)(3)(A); Prop. Regs. Sec. 1.529-3(b)(1)(i).

¹⁸Secs. 529(c)(6) and 530(d)(4). In addition, the 10% penalty does not apply if the payment is made to the estate of the beneficiary upon the beneficiary’s death or is attributable to the beneficiary’s becoming disabled (IRS Publication 970, Tax Benefits for Education, p. 53 (2022)).

¹⁹See BlackRock Inc., “Take Advantage of Your State Tax Benefits.” Also, each state that offers a 529 plan has a website that provides the details of the plan.

²⁰See Oey, “Morningstar 529 Ratings: The Top Plans and What They Offer,” Morningstar Fund Spy (Nov. 2, 2022).

²¹Secs. 529(c)(3)(C)(i)(1) and 529(c)(3)(C)(i)(11). See IRS Publication 970, Tax Benefits for Education, pp. 53–54 (2022), for a complete list of eligible related family members.

²²Sec. 529(c)(3)(C)(iii).

²³Sec. 529(c)(3)(C)(i).

²⁴Sec. 529(c)(5)(A).

²⁵Sec. 529(c)(5)(B).

²⁶Sec. 529(c)(4)(A).

²⁷Sec. 529(c)(4)(C).

²⁸Sec. 408A(d)(2).

²⁹Sec. 408A(c)(2) and IRS News Release IR-2022-188 (10/21/22).

³⁰Sec. 408A(c)(3) and IR-2022-188 (10/21/22).

³¹Section 126 of the SECURE 2.0 Act of 2022, Division T of the Consolidated Appropriations Act, 2023, P.L. 117-164, amending Secs. 408A and 529.

³²Sec. 408A(d)(4).

³³Secs. 72(t)(2)(E) and 529(e)(3).

³⁴Flynn, “Does a 529 Plan Affect Financial Aid?” Saving for College (July 26, 2022); Lankford, “How Roth IRAs Affect Financial-Aid Eligibility,” Kiplinger (March 8, 2012).

Contributor

Richard Toolson, CPA, Ph.D., is a professor of accounting at Washington State University. For more information about this article, contact thetaxadviser@aicpa.org.

AICPA RESOURCES

Articles Long, “Saving for College: The New 529-to-Roth-IRA Transfer Rule,” Journal of Accountancy (March 6, 2023)

Reed, “Tax Incentives for College Students: Part 2,” Tax Insider (Oct. 1, 2020)

Reed, “Tax Incentives for College Students: Part 1,” Tax Insider (Sept. 24, 2020)

Jones and Hamm, “Look Before You Leap Into a 529 Plan,” Journal of Accountancy (June 2020)

Podcast episode

“Rolling Excess 529 Plan Funds Into Roth IRA Accounts,” AICPA PFP Section podcast (Feb. 9, 2023)

CPE self-study

Education Planning

For more information or to make a purchase, visit aicpa-cima.com/cpe-learning or call the Institute at 888-777-7077.