Using a §529 plan to pay for higher education costs can be a great tax savings tool in itself; although contributions are not tax deductible federally or for California, they are deductible in 34 other states. All withdrawals and earnings are tax-free if used to pay for qualified higher education expenses (“QHEE”) for a designated beneficiary. The plans can be transferred to any ‘qualified member’ of the beneficiary’s family (as defined by the IRS in Pub. 970), so the funds do not have to be lost if there is excess after the first beneficiary completes their higher education or decides not to use it at all.
For estate planning purposes, the §529 accounts do not count towards the owner’s gross estate for estate tax purposes. However, contributions to §529 plans are considered a gift, so any contribution exceeding the annual one-time gift exclusion ($14,000 for 2015) or exceeding $70,000 in a five-year period can be subject to the gift tax.
To maximize the benefits of a §529 plan, it is important to keep track during the year of the amount of funds withdrawn from the §529 versus the actual amount of QHEE incurred. If one can benefit from the American Opportunity Tax Credit, consider paying $4,000 of QHEE with non-§529 funds to receive the full credit. Alternatively, you can pay all QHEE with §529 funds, elect to report $4,000 as a non-qualified distribution, and pay the income tax and possibly the penalty on the earnings. This advanced tactic should be discussed with a tax professional – please contact us for assistance on this matter.
If the §529 withdrawals exceed QHEE for the year, you have a few options before being stuck with the 10% penalty and income tax on the earnings. If the last withdrawal that exceeded QHEE for the calendar year was within 60 days, you can rollover the excess amount into a different §529 plan so the amount is no longer treated as a distribution. If the withdrawal was more than 60 days ago, but within the same calendar year, you can prepay next year’s expenses to increase your current QHEE.
In the event the beneficiary receives a full scholarship covering all QHEE (or even partial assistance), there is still a way to pull out the funds and avoid the 10% penalty. The beneficiary can withdraw up to the amount of any scholarship/nontaxable assistance received in a calendar year without penalty. The earnings will be subject to income tax, but you’ve essentially deferred the tax over the years of earnings.
It is important to plan when using §529 plans as using too much or too little can complicate your tax situation. Remember to consult with your financial and tax advisors to make sure you are utilizing your §529 plans to their full potential.
You can read more suggestive tips for using §529 plans here.