Overview – Income tax savings:
College savings plans, known as 529 plans, derive from Internal Revenue Code Section 529 which provides income tax benefits for college savings. Investments in 529 plans grow tax-free, and withdrawals are not federally taxable. Any person (the account “custodian”) can open a 529 account for a beneficiary, so long as both the account custodian and beneficiary are either a US citizen or resident alien. Funds can be used for the following expenses at eligible educational institutions: tuition, fees, books, certain room and board expenses and certain equipment expenses. Funds may also be used for post-graduate programs and certain apprenticeship program expenses. There is no age limit for a beneficiary to use the funds for educational expenses. If funds are withdrawn for a non-educational purpose, there will be a 10% tax penalty imposed, along with the withdrawal being subject to income taxes. Although the Code Section was created to provide for college savings, the 2017 Tax Cuts and Jobs Act expanded the use of 529 account funds to include tuition expenses of up to $10,000 per year for K-12 public, private or religious school. Funds may also be used to pay up to a total of $10,000 of principal or interest on qualified student loans of the beneficiary of a 529 plan, and funds from the same 529 account can also be used for loan repayment of up to a total of $10,000 for each of the beneficiary’s siblings.
529 plans are offered by the states, many of which allow participation by state residents and non-residents. However, many states offer additional tax benefits for their residents who participate in their state plan. For example, New York state allows an income tax deduction of up to $10,000 for New York joint filers for contributions to NY 529 plan accounts, and all withdraws are also exempt from New York state income tax. However, New York state tax benefits do not apply to withdraws for K-12 tuition or education loan repayments. Contribution limits to 529 plans also depend on the state; in New York, you may not contribute additional funds to a 529 plan account if it has reached a balance of $520,000. However, the account balance may increase beyond $520,000 from earnings and appreciation without penalty.
Gift Tax Rules:
Contributions to a 529 plan are considered gifts under Internal Revenue Code Section 2503. However, they are not excluded under the gift tax education exemption, as that only applies to direct tuition payments to an educational institution. The gift tax annual exclusion of $16,000 (or $32,000 for joint filers) per gift recipient is available for contributions to 529 plans, therefore contributions at or below these levels will not be subject to gift tax. A person may contribute up to $80,000 (or $160,000 for joint filers) to a 529 account in one year if a special election is made on a timely filed gift tax return; however, such contribution would use up the donor’s gift tax annual exclusion amount for five years.
Although 529 plans have significant tax advantages, they may affect the Medicaid eligibility of an account’s custodian. In order to be financially eligible for Medicaid, a person must have assets below a certain threshold (currently $16,800 for an individual in New York). Generally assets for this calculation include a custodian’s 529 plan, even though it is intended for use by a beneficiary for education expenses. Since the custodian has the ability to withdraw the funds for any purpose and revoke the account, the funds (less any withdrawal penalties) are considered resources of the custodian for Medicaid eligibility purposes. Furthermore, funds already withdrawn from a 529 plan account for educational expenses could be viewed as gifted assets of the custodian for purposes of the 5-year look-back rule. As a result, Medicaid payments for the account custodian would be delayed for a period of time corresponding to the amount of funds withdrawn from the account on behalf of the beneficiary over the 5 previous years. Grandparents who would like to help fund their grandchildren’s college expenses should consider contributing to 529 accounts owned by their children, or if they have already opened a 529 account, transferring ownership of the account to their child.
If you’d like to discuss the specifics of your 529 plan, please reach out to the Trust and Estate team at Hollis Laidlaw & Simon P.C. for a complimentary consultation.