Five (529 Plan) Hacks to Pay for College

August 10, 2022

College may seem distant from these long days of summer, but many students will soon start fall semester. Because of staggering growth in college costs over the past two decades, families face difficult challenges and decisions about how to fund their aspiring student’s higher education. Some will turn to financial aid, while others will tap into savings or existing income streams. Tax-advantaged education plans have grown enormously popular in recent years, and the 529 is worth considering, especially by parents of young children. Although it’s a great savings tool as is, a 529 plan can be further optimized with some little-known tricks.

1. Know the tax advantages on both the federal and state levels

Congress enacted Section 529 of the IRS tax code in 1996. Five years later, the Economic Growth and Tax Relief Reconciliation Act of 2001 made qualified distributions from 529 plans tax-exempt. To qualify for tax exemption, distributed funds can be spent only on certain expenses, such as tuition, books, supplies, computers, and software.¹ Since passage of the law, changes have been made to 529 plans that allow for reimbursing K–12 costs (up to $10,000 per year, per beneficiary) as well as student loans (up to $10,000 in a lifetime).

A 529 plan has many advantages. For example, funds within the plan grow and are distributed tax-free. Also, the contribution limits are high: currently you can deposit up to $16,000 per year into a 529 plan for each beneficiary (married couples can double this amount) without filing a gift tax return. Those who want to supercharge their contributions can make up to five years of deposits in a single year by filing Form 709 with their federal income tax return. Some states, like my home state of Colorado, offer a state income tax deduction for 529 plan contributions made by residents. If your state has an income tax, check here for the potential advantages and rules regarding 529 plans.

What if you fund a 529 plan and the beneficiary doesn’t seek higher education? In that case, you can designate a new beneficiary. There are no income tax consequences for changing the beneficiary of a 529 account if the new beneficiary is a member of the same “family.” The definition of a family member is very broad and includes siblings, children, descendants, and cousins. If funds are withdrawn for unqualified expenses, any earnings are subject to state and federal taxes plus a 10% penalty.² In other words, the only way to reap the full tax advantages of a 529 plan is to spend the distributions on qualified education expenses.

2. Manage your plan distributions effectively

There are cases when you shouldn’t pay for higher-education expenses with a 529 plan. A common example is when you’re claiming the American Opportunity Tax Credit (AOTC), which is a federal income tax credit of up to $2,500 for those who spend $4,000 on qualified college expenses, including tuition, fees, and books.

Getting more than 60% of higher-education costs refunded is a remarkable benefit, but a caveat is that you cannot use a withdrawal from a 529 account for an expense that will qualify for the AOTC. Keep in mind that the full AOTC is available only to those who have a modified adjusted gross income of $80,000 or lower, with married couples having a limit of $160,000. The same rules for double dipping apply to the Lifetime Learning Credit (LLC), which can be up to $2,000 per tax return.

If you’re likely to qualify for either the AOTC or LLC, you’ll probably want to pay for at least some higher-education expenses with funds outside of a 529 plan. It might even make sense for your student to take out a federal student loan, if needed, to qualify for one of these generous credits.

3. Exercise enhanced option for grandparents

For many years, the federal student aid formula penalized 529 plan distributions from accounts owned by people who are not the parents of the beneficiary, such as grandparents. With the passage of the Consolidated Appropriations Act 2021, however, the U.S. Department of Education is now revising federal financial aid rules for the 2024–2025 application year.

Prior to the rule change, distributions from a grandparent’s 529 plan were reported as untaxed student income and would potentially jeopardize the student’s qualification for needs-based financial aid by up to 50% of the amount of the distribution. For example, taking a $10,000 distribution to pay for qualified education expenses can reduce the grandchild’s aid eligibility by $5,000. Under the revised rule, distributions are no longer reported as untaxed student income and therefore don’t affect aid eligibility. In short, revised rules mean grandparents and other family members can use 529 accounts with less concern about jeopardizing the financial aid of the intended recipient.

4. Plan for multiple generations

529 plans aren’t just for your children. If your state, like Colorado, is one of the more than 30 that allow a state income tax deduction for 529 contributions, it might make sense to contribute to a plan to fund your own higher education at an eligible institution.

As mentioned earlier, grandparents and other family members can start a 529 plan for a beneficiary. If funds are left over in a 529 account after the beneficiary finishes their higher education, the account beneficiary can be changed. If you’re serious about funding so-called Dynasty 529 accounts to cover college costs for multiple generations, you should be aware that gift tax rules may apply. Consult a financial professional for guidance on your situation.

5. Use the 529 college coupon

This last tip applies if your state (check here) offers a tax advantage for a 529 plan contribution, in the form of a tax credit or deduction. If you’re funding college costs with your cash flow rather than savings, it might make sense to first deposit funds into a 529 plan even if you intend to distribute the funds soon afterward. If allowable by your state and plan, you could qualify for a state income tax benefit even if the funds are in the plan for just a short time.

Not all 529 plans are created equal, which is why it’s important to find a plan that has low costs and diversified investment options. If your state offers a tax advantage for 529 plan contributions, make sure your chosen plan qualifies. Talk to your advisor and consult resources for identifying the right plan for you and your family.

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