Qualified tuition programs, also known as 529 plans, allow a taxpayer to set up a specified account for the purpose of paying the qualified education expenses of a designated beneficiary at an eligible educational institution. The benefit of setting up a 529 plan comes from the fact that distributions, including any gain that may have accrued from the time of initial contribution, are tax free. So in this way, qualified tuition programs are similar to Roth IRAs in that the money is taxed on its way into the 529 plan, but not on its way out, assuming protocol is met with regards to how those funds are spent.
Like so many topics in education, the terms in the aforesaid introduction have to be broken down in order to fully understand how 529 plans work. First, an eligible educational institution is a primary, secondary, or post-secondary school (including vocational schools), which can be either public or private, and has the general accreditation that one would expect of such a place of learning. Notice that you can use 529 plans to also pay the tuition for elementary, middle, and high school, which shows that this is a general educational account for pretty much any student above the age of four. Note also that a designated beneficiary is the student or future student for whom a specific qualified tuition program account pays the qualified education expenses at a chosen school.
Rounding out the definitions, qualified education expenses are those expenses that have to be paid in order for a student to attend a particular school. There are two types of qualified education expenses – qualified higher education expenses and qualified elementary and secondary education expenses. Qualified higher education expenses are things such as tuition and fees, books, supplies and equipment, special needs services (if a need is demonstrated), room and board, a computer or peripheral equipment (if used for educational purposes), necessary costs of apprenticeship programs, and no more than $10,000 in principal and interest on student loan payments.
Look at that last one! You can actually pay up to $10,000 in student debt for the intended beneficiary, or his or her sibling, using a qualified tuition program, which is pretty cool. However, this is a $10,000 lifetime limit, meaning that it’s not a per year allowance; it’s a cumulative limit over the life of the student’s educational career. Moreover, qualified elementary and secondary education expenses are tuition, up to $10,000 per year, paid for a given elementary, middle, or high school, which can be public, private, or even parochial (religious).
In terms of contribution, you can contribute up to the amount of qualified education expenses associated with a given beneficiary, assuming that it does not eclipse a limit previously delineated in this article. Furthermore, one’s ability to contribute to a qualified tuition program is not subject to gross income limitations or phase out. So, if he were so inclined, Jeff Bezos himself could set up a 529 plan for his kids. You can also contribute to both a 529 plan while also contributing to a Coverdell ESA, for a particular beneficiary.
As was mentioned in the beginning of this article, the major benefit of qualified tuition programs is that post tax contributions earn tax free income, assuming the distributions from the 529 plan are used to pay qualified expenses, as those are defined for a specific type of educational institution. To keep the initial contributions and the earnings from those contributions separate and accounted for, the taxpayer who sets up a 529 plan will receive a Form 1099-Q, showing the gross distribution in box 1, the earnings portion of that gross distribution in box 2, and that portion of the gross distribution made up of the initial contributions in box 3.
While it is true that generally distributions from qualified tuition programs are tax free, if the amount of the annual distribution is greater than the qualified education expenses, the overage of the earnings from that distribution is taxable. Note that only the earnings from the distribution that eclipse education expenses are taxable. This makes logical sense because the initial contribution amounts were already post-tax. Additionally, any tax free scholarships and grants must be subtracted from the amount of education expenses for the purposes of determining a gross distribution’s taxability. This also makes sense due to the IRS’s general prohibition against a double benefit stemming from the same dollar of expenses.
Furthermore, as long as the same educational expenses are not double counted, the American opportunity credit and lifetime learning credit may be taken in a year where you also received a 529 plan distribution. So, for example, if you had $20,000 in college tuition, and you received a $5,000 tax free scholarship and a $10,000 qualified tuition program distribution, then you could still use $5,000 of that college tuition bill that is left over to figure either the American opportunity credit or lifetime learning credit. This same general principle applies for the tuition and fees deduction, meaning as long as the educational expenses are not double counted, you can take a tax free distribution and the tuition and fees deduction in the same tax year.
Whatever portion of your gross distribution from your 529 plan that is subject to the income tax is also subject to an additional 10% tax. However, there are several exceptions to this additional 10% tax, which are: 1) payments to a beneficiary after death of the designated beneficiary; 2) disability; 3) inclusion in income due to tax free educational assistance such as scholarships or employer educational assistance; 4) distributions used for a U.S. military academy; and 5) inclusion in income due to education credits. Also note that if you must pay this additional 10% tax, figure and account for it using Form 5329, Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts.
Finally, you should understand that, like IRAs and 401(k)s, distributions from 529 plans are not taxable if those distributions are rolled over into another 529 plan or an ABLE account, with the latter being a tax-advantaged account associated with disabled individuals. Any rollover of a qualified tuition program distribution must take place within 60 days of the initial distribution. What’s more, a rollover can occur between members of the same family (i.e. children, siblings, parents, nieces/nephews, in-laws, first cousins, and spouses) and also avoid taxation. This is a good trick to use if there is money left over in a 529 plan after the student no longer has any more qualified educational expenses. The same rule applies for changing the designated beneficiary, meaning you may do so with no tax implications if the change occurs within the same family.
If you are interested in other tax benefits surrounding education, please refer to IRS Publication 970.
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