Tax reform provided a tool that’s such a good way to help pay for a grandchild’s education that many
states are worried it will break their budgets.
You’re probably familiar with 529 college savings plans. These are sort of like Roth IRAs for college
savings. They were created in the 1990s. Every state sponsors one or more 529 savings plans.
In a 529 savings plan, you contribute money to an account and name a beneficiary for the
account, usually one of your children or grandchildren. The money in the account is invested, and the
income and gains compound tax free. Some plans let you choose how the account is invested from
among mutual funds selected by the plan sponsor. In other plans, the sponsor decides how the money
is invested or allows you to choose from several diversified portfolios it manages.
When money is distributed from the account to pay for qualified educational expenses, the distribution
of the principal and earnings is tax free. If a distribution isn’t used to pay for qualified education expenses, the earnings are taxable and there likely will be a 10% federal tax penalty.
There also are estate and gift tax benefits. Contributions to an account qualify for the annual gift tax
exclusion. So you can deposit up to $15,000 per account beneficiary in 2018 without worrying about
the effect on your lifetime estate and gift tax exclusion. In addition, you can bundle up to five years of
annual gifts in one year, allowing you to make up to $75,000 of taxfree contributions per beneficiary
in one year.
You can change the account beneficiary. You even can take the contributions back for any reason without tax consequences, though there might be a penalty of up to 10%.
The Tax Cuts and Jobs Act of 2017 increased the benefits of 529 savings plans. Previously, the plans could be used to pay only for post-secondary school expenses. Under the new law, the plans also can be used to pay for up to $10,000 of tuition annually for kindergarten through grade 12. The $10,000 is per student, not per account. Therefore, a student who is a beneficiary of multiple accounts can have only a total of $10,000 distributed tax free each year to pay for K-12 expenses. Excess distributions are included in gross income.
Only tuition for grades K-12 qualifies for a tax-free distribution. Expenses other than tuition don’t
qualify for a tax-free distribution. (The definition of qualified expenses is broader when the money is
used for secondary education.)
The school can be public, private, or religious.
More than 30 states allow full or partial deductions for contributions to 529 plans; some allow other benefits, such as tax credits, instead of deductions. Some states allow their residents to take deductions
or credits only for contributions to a plan sponsored by the state, while others allow the tax breaks for contributions to any 529 plan.
If you’re helping pay for private school tuition of a child or grandchild and your state allows a tax
break for 529 account contributions, consider opening an account with the youngster as a beneficiary. Contribute to the account an amount at least equal to the maximum state tax benefit. When tuition is due, distribute an amount equal to the tuition.
Read your state law closely. Some states, such as New York, limit the tax breaks only for college-related expenses. They’re debating whether to change their laws to match the new federal law. Also, many states are worried the federal law change will increase use of the plans and cost the states tax revenue. They’re considering reducing or eliminating the state tax benefits. So, if this is attractive to you, take advantage of the benefits while you can.