The ABCs of 529 Plans
By Brett Newberry
Several years ago I wrote an article in the Gallup Journey about 529 plans. I thought this was a good time to revisit the issue.
If you are already saving for college, you have probably heard about 529 plans. 529 plans are revolutionizing the way parents and grandparents save for college. Americans are pouring billions of dollars into 529 plans, and contributions are expected to increase dramatically in the future. Where did these plans come from, and what makes them so attractive?
Congress created Section 529 plans in 1996 in a piece of legislation that had little to do with saving for college. The law on 529 plans was later refined in 1997, 2001, and 2006. 529 plans have emerged as one of the top ways to save for college. Section 529 plans are officially known as qualified tuition programs under federal law. The reason “529 plan” is commonly used is because 529 is the section of the Internal Revenue Code that governs their operation.
A 529 plan is a college savings vehicle that has federal tax advantages. There are two types of 529 plans: college savings plans and prepaid tuition plans. This article will only focus on college savings plans since those are the only plans offered in New Mexico.
College savings plans let you save money for college in an individual investment account. These plans are run by the states, which typically designate an experienced financial institution to manage their plan. To open an account, you fill out an application, choose a beneficiary, and start contributing money. However, you can’t hand pick your own investments as you would with a Coverdell Education Savings Account, custodial account, or trust. Instead, you typically choose one or more portfolios offered by the plan, the underlying investments of which are exclusively chosen and managed by the plan’s professional money manager. After this, you simply decide when, and how much, to contribute. When it’s time for college, the beneficiary of your account can use the funds at any college in this country.
Can 529 funds be used for general living expenses while at college? No. The federal definition of “qualified education expenses” that most colleges use doesn’t include general living expenses (i.e. phone charges, transportation). To be covered, expenses must be for something required for enrollment and attendance (i.e. books, lab fees, tuition), and most living expenses don’t fit into this category. Withdrawals for nonqualified expenses will generally be subject to income tax and an additional 10% federal penalty tax on earnings.
Can a 529 account have more than one beneficiary? A 529 account can have only one beneficiary. If you have more than one child, you may want to open a 529 account for each. Alternatively, you could open one 529 account and after funds have been withdrawn for your first child’s college expenses, change the designated beneficiary of the remaining funds to your second child. However, this change of the designated beneficiary could have gift tax consequences.
There is favorable federal gift and estate tax treatment related to contributions to a 529 plan. Contributions qualify for the $13,000 annual gift tax exclusion. And with a special election, you can contribute a lump sum of $65,000 to a 529 plan, treat the gift as if it were made over a five-year period, and completely avoid gift tax. Your plan contributions aren’t considered part of your estate for federal tax purposes. You still retain control of the account as the account owner but you don’t pay a federal estate tax on the value of the account.
There is no federal income tax deduction allowed related to contributions made to a 529 plan. However, if you contribute to a New Mexico 529 plan and you are a resident of New Mexico, then you are allowed to deduct those contributions on the New Mexico income tax return. New Mexico offers two 529 college savings plans: Scholar’s Edge and The Education Plan. The Scholar’s Edge Plan can be purchased through a financial advisor and The Education Plan can be purchased directly or through a financial advisor.
I have used 529 plans to fund the college education of my children, and I continue to use 529 plans to fund the future college education of my grandchildren. My oldest grandchild will not be ready to start college for another 7 years. However, since the cost of college education continues to rise approximately double the annual inflation rate, you can never start too early funding a 529 plan!
Until next time,
The Business Doctor