4 key facts about Section 529 plans

As students head back to the classroom this month, education is on the minds of parents across the country. However, one key concern of parents — whether a child is just starting kindergarten or is off to high school — is how to fund the rising cost of college.

A Section 529 plan allows savings to be accumulated for a designated beneficiary’s higher education on a tax-favored basis. Contributions to a Section 529 plan are not deductible. However, earnings are not taxable while they remain in the account. In addition, amounts withdrawn from the account (including earnings) are not taxable to the extent they are used to pay qualifying education expenses of the designated beneficiary. Many states offer favorable tax treatments for contributions to their state-owned Section 529 plan.

Chances are many of your clients have set up Section 529 plans for their offspring. According to recent statistics, there were 14 million 529 accounts in existence as of June 2019, and that number is growing each year. However, chances are also that your clients may not be aware of all the ins and outs of 529 plans.

Here are four key facts about Section 529 plans that your clients may not know.

#1: Section 529 plans can pay for more than tuition

Clearly, saving for college tuition bills is first and foremost in your clients’ minds when setting up a Section 529 plan. However, although Section 529 plans are formally known as Qualified Tuition Programs (QTPs), qualified expenses that can be paid on a tax-favored basis are not limited to tuition costs. Funds in a 529 plan can be withdrawn tax-free to pay for other college expenses, including fees and the cost of books, supplies, and equipment required for college enrollment. Eligible expenses also include the costs of computers and peripheral equipment, software, or internet access, provided they will be used primarily by the account beneficiary while enrolled at an eligible educational institution. A 529 plan can also be used to cover room and board costs for a student enrolled at least half time.

#2: Section 529 plans are not just for college

Under a new rule enacted by the 2017 Tax Cuts and Jobs Act, Section 529 plans are no longer just for college savings. Parents can now use 529 plans to save for the costs of private elementary or secondary school tuition. Effective for distributions made after 2017, qualified Section 529 plan expenses include up to $10,000 per year for a student’s tuition at an elementary or secondary public, private, or religious school.

And, thanks to law changes made by the recently enacted SECURE Act, distributions made after Dec. 31, 2018, can be used to cover costs associated with registered apprenticeships and up to $10,000 of qualified student loan repayments (principal or interest). The $10,000 limit on loan repayments applies on a per-student basis. However, the law permits funds in a 529 plan to be used for student loan payments on behalf of a sibling of the designated account beneficiary.

#3: Section 529 savings count for financial aid calculations

Under the federal financial aid rules, both parents’ and students’ assets are counted in calculating the Expected Family Contribution (EFC) toward a student’s college costs — that is the amount the family can expect to pay for a year of college before any financial aid kicks in. Under the formula, a student’s assets count more toward the EFC than do the parents’ assets. A student’s assets are counted at a flat 20% rate. By contrast, a portion of the parents’ assets are sheltered by an asset protection allowance based on the age of the older parent. Moreover, parental assets above the allowance are counted at a rate of only 5.64%.

The good news is that funds in a Section 529 plan are treated as the parents’ assets, regardless of whether the student or the parents own the account. Thus, only 5.64% of 529 plans funds are taken into account in calculating the EFC.

COMPARE: Many of your clients may take a first-come, first-served approach to savings. When faced with a choice between making retirement plan and 529 plan contributions, parents may opt for the latter. After all, the bill for a child’s college tuition is likely to come due long before retirement. However, parents should bear in mind that funds in a qualified retirement plan are not counted as assets on applications for federal financial aid — although any current-year contributions or withdrawals are counted.

#4: Section 529 plans are not just for parents

Grandparents and other relatives can set up a Section 529 plan for a child, while maintaining ownership and control over the account. While contributions to a Section 529 plan are made with after-tax dollars, the funds grow and compound tax-free while in the account — and, of course, distributions are potentially tax-free if used for the account beneficiary’s qualified education expenses. On the other hand, if a grandparent requires funds for their own needs, a 529 plan is revocable. The account owner will owe tax and a 10% penalty, and may be subject to state income tax — but only on the earnings portion of the account.

One potential source of 529 plan contributions for grandparents are the required minimum distributions (RMDs) they must take from a qualified retirement plan. The recently enacted SECURE Act has pushed back the age for RMDs from 70 ½ to 72. Nonetheless, some grandparents are faced with the prospect of taking retirement plan distributions that they don’t need. Since these distributions have already been taxed, funneling the money into a 529 plan for a grandchild will allow for further tax-free growth.

For federal financial aid purposes, funds in a 529 plan owned by a grandparent or other relative are not reported as either the parents’ or students’ assets and aren’t subject to financial aid calculations until withdrawn and given to the student. On the other hand, distributions from the plan for the child’s college costs are counted as part of the child’s income for the year of the distribution. However, taking a last-out approach to such distributions — for example, waiting until the child’s last year of college to tap grandparent-owned 529 funds — can minimize the impact on financial aid.

CAUTION: Colleges have their own rules for figuring financial aid. While some follow the federal formula, others may ask about 529 plans held by grandparents or other relatives when awarding scholarships or grants.