529 Prepaid Tuition Plans

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What is it?

A prepaid tuition plan is a type of qualified tuition program (the other type is a college savings plan) established under Section 529 of the Internal Revenue Code. Prepaid tuition plans can be offered either by states (called state-sponsored prepaid plans) or by private colleges (called college-sponsored prepaid plans).

State-sponsored prepaid plans are the original type of prepaid tuition plan. These plans are generally intended to cover undergraduate tuition costs at in-state public colleges. Note: Unless otherwise noted, this discussion applies to state-sponsored prepaid plans.

A prepaid tuition plan lets you prepay some or all of a beneficiary’s undergraduate college tuition at today’s prices for use in the future. Although the details of prepaid tuition plans vary by state, the basics are generally the same:

  • You, a grandparent, or anyone else open an account with a particular prepaid tuition plan and designate a beneficiary. The beneficiary does not need to be related to you. The person who opens the account is called the account owner (or sometimes the participant). As account owner, you decide when contributions and withdrawals are to be made. A prepaid tuition plan account can have only one account owner and one beneficiary at a time.
  • Once the account is open, you (or anyone else) can contribute as much money in the account as you wish, subject to the plan’s specific limits. Some plans may require a minimum amount to open the account or a minimum amount per contribution. Plans may also restrict the total contributions allowed in one year. All plans have total lifetime contribution limits.
  • There are generally two ways to purchase tuition credits–a contract plan or a unit plan. With a contract plan, in exchange for your up-front cash contribution (or series of contributions), the plan promises to cover a predetermined amount of future tuition expenses at a public college within that state. For example, if your cash payment buys you three years worth of college tuition today at State University, then the plan might promise to cover two and a half years of tuition expenses at State University in the future when your beneficiary will attend. With a unit plan, you purchase units or credits that represent a percentage (typically 1 percent) of the average yearly tuition costs at public colleges within your state. But instead of having a predetermined value, the units fluctuate in value each year according to the average tuition increases for that year at in-state public colleges. In this way, you are guaranteed to keep pace with the rate of inflation at public colleges within your state.
  • When you make a contribution to a prepaid tuition plan, your money is pooled into a common fund with contributions from other account owners. The state then invests the money in this common fund to meet its individual obligations under the plan. (At a minimum, the state hopes to earn the difference between your contributions and what it has promised your contributions will be worth when your beneficiary goes to college.) Because you know how much future tuition you are purchasing when you make a contribution, you don’t need to be concerned with the investment performance of the common fund.
  • When you need to tap funds in the account for the beneficiary’s tuition expenses, you notify the plan administrator. Funds in a prepaid tuition plan account are generally intended for tuition costs only, though a plan may agree to cover room and board as well. If the beneficiary doesn’t attend a participating college (for state-sponsored plans, this means an in-state public college), you will typically receive a refund of your principal and, in some cases, a nominal amount of interest. You may also owe a penalty.

Tip:  Investors should consider the investment objectives, risks, charges, and expenses associated with 529 plans before investing. More information about specific 529 plans is available in each issuer’s official statement, which should be read carefully before investing. Also, before investing, consider whether your state offers a 529 plan that provides residents with favorable state tax benefits.

Strengths

Prepaid tuition plans are unique in the combination of advantages they offer college investors.

You can lock in future college tuition at today’s prices

Prepaid tuition plans let you prepay a specific amount of college tuition at today’s prices for use by your beneficiary in the future. By doing so, you gain some control and predictability over spiraling college costs. Before making a contribution, make sure you understand exactly how much tuition you are purchasing.

Contributions grow tax deferred

The money you contribute to a prepaid tuition plan grows income tax deferred at both the federal and state levels. This means that instead of paying income tax each year on your earnings, any income taxes are deferred until the time you make a withdrawal.

Withdrawals used for the beneficiary’s qualified education expenses are income tax free at the federal level

Earnings on money invested in a prepaid tuition plan are completely free from federal income taxes if the funds are used to pay the beneficiary’s qualified education expenses (called a qualified withdrawal). Most prepaid tuition plans limit qualified education expenses to the beneficiary’s undergraduate tuition costs only.

Contributions receive favorable federal gift and estate tax treatment

Contributions to a prepaid tuition plan are considered completed, present-interest gifts for federal gift tax purposes. This means that they qualify for the $14,000 federal annual gift tax exclusion. And by making a special election, you can contribute up to $70,000 in a single calendar year and spread the gift equally over five years to avoid gift and estate tax.

Also, your plan contributions generally aren’t considered part of your estate for federal gift and estate tax purposes, even though you retain control of the account while you’re living. But there is an exception: If you contribute more than the $14,000 annual gift tax exclusion amount, spread the gift over five years using the special election, and then die within the five-year period, you may owe federal gift and estate tax. For more information, see the Tax considerations section below.

States may offer their own state tax incentives

In addition to federal tax benefits, states may offer tax incentives on prepaid tuition plan contributions and withdrawals. Examples include a deduction for contributions, an income tax credit for contributions, or a full or partial exemption of earnings from state income tax when a withdrawal is used to pay the beneficiary’s qualified education expenses.

Tip: If your state does tax the account’s earnings (even when the withdrawal is used for the beneficiary’s qualified education expenses), it will likely do so at the beneficiary’s (child’s) tax rate.

Participation is not restricted by income level

Prepaid tuition plans are open to all individuals, regardless of income. This is a distinct advantage over Coverdell education savings accounts, which restrict participation based on income.

Total lifetime contribution limits are high

The total amount you can contribute to a prepaid tuition plan is high. Typically, the limit is equal to the expected future cost of five years of tuition at the most expensive participating college.

Opening an account is easy

It’s simple to open a prepaid tuition plan account. You fill out a short application, designate a beneficiary, pay the enrollment fee, and contribute the required minimum amount (if any) to open the account.

You have a rollover option once every 12 months

You can roll over your existing prepaid tuition plan account to a new 529 plan account (prepaid tuition plan or college savings plan) once every 12 months without any federal tax penalty and without having to change the beneficiary. (But the state sponsoring the plan may impose a cost or penalty, so check the plan’s rules before you do the rollover.) This option lets you leave a plan you are no longer happy with for a plan that offers the features you want.

Tradeoffs

Though prepaid tuition plans let you keep up with rising tuition costs, they do have some drawbacks.

The beneficiary earns maximum benefits only by attending a participating college

State-sponsored prepaid tuition plans are designed to cover undergraduate tuition costs at in-state public colleges. If the beneficiary doesn’t attend a participating college, he or she will not receive the maximum benefits under the plan. Instead, typically you will receive a refund of your principal and, in some cases, a nominal amount of interest. You may also owe a penalty.

Tip: Before you contribute to a prepaid tuition plan, make sure to find out how much you will get back if the beneficiary doesn’t attend a participating college. Remember, too, that simply joining a prepaid tuition plan doesn’t mean that the beneficiary will automatically be accepted at a participating college–the admissions process is completely independent of the prepaid tuition plan.

Room-and-board expenses and graduate school expenses generally aren’t covered

The federal definition of qualified education expenses includes unreimbursed college and graduate school expenses for tuition, fees, books, supplies, and required equipment, and room-and-board expenses if the beneficiary attends school at least half-time. Also, qualified education expenses include the cost of computers, software, and internet access while the beneficiary is in college. But a state’s definition can be more restrictive, and in fact, most state-sponsored prepaid tuition plans define qualified education expenses to mean only the beneficiary’s undergraduate tuition costs. (By contrast, college savings plan funds can be used to cover tuition, fees, books, equipment, and, if the beneficiary attends school at least half-time, room-and-board expenses for college and graduate school.) Before joining a prepaid tuition plan, check to see exactly what constitutes a qualified education expense.

The beneficiary may need to use the account funds in a certain period of time

Most prepaid tuition plans require that all withdrawals be completed within 10 years of the time the beneficiary starts college, and that all withdrawals be made (or tuition credits used) by the time the beneficiary reaches age 30. Also, at some point before the beneficiary starts college, you (as account owner) must notify the plan as to when you intend to start making withdrawals.

Withdrawals not used for the beneficiary’s qualified education expenses are taxed and penalized

If you make a nonqualified withdrawal–a withdrawal used for something other than the beneficiary’s qualified education expenses–the tax result depends on the type of prepaid tuition plan you have. If you have a contract plan, your only option if you want to get money out of the plan is to cancel your contract and obtain a refund. Some plans will return only your actual contributions, with no interest or earnings, while other plans will refund your contributions plus a nominal amount of interest. The interest you receive will be taxed at regular federal (and probably state) income tax rates. In addition, the earnings portion of the withdrawal will be subject to a 10 percent federal penalty.

If you have the unit type of prepaid tuition plan, the tax treatment is the same as for college savings plans. Specifically, the earnings portion of the withdrawal will be taxed at the federal level at the income tax rate of the person who receives the distribution (usually the account owner), and state taxes will probably apply, too. In addition, the earnings portion of the withdrawal will be subject to a 10 percent federal penalty.

You may do better investing on your own

Though prepaid tuition plans typically guarantee a minimum rate of return, they differ on how much additional return you’ll receive if the plan’s investment return exceeds the promised rate of return. In a strong market, you may be able to earn a better rate of return by investing on your own.

Fees and expenses

Fees and expenses are typically associated with opening and/or maintaining a 529 account (e.g., annual maintenance and administration fees, and investment expenses based on a percentage of your total account value).

Opening an account

Opening a prepaid tuition plan account usually requires following a few easy steps.

Select a plan

Prepaid tuition plans don’t provide as much choice as college savings plans. Most prepaid tuition plans restrict participation to their own state residents, though there are a couple of exceptions. (By contrast, college-sponsored prepaid tuition plans don’t limit participation by state of residence.) Here are some basic questions you should ask about any prepaid tuition plan you’re considering:

  • Can the beneficiary be any age when the account is opened?
  • Are there specific enrollment periods during which the account must be opened?
  • Are other college expenses covered besides tuition?
  • Must the account funds be used by the time the beneficiary reaches a certain age?
  • What happens if the beneficiary doesn’t attend an in-state public college?
  • What are the fees associated with opening and maintaining the account?
  • Does the plan limit (by time or amount) the contributions that can be made?

Complete an account application

After you review the materials in a plan enrollment kit, fill out and sign the application. You can request an application by phone or mail from the plan administrator. Alternatively, nearly every state that offers a plan now has a downloadable version of its application on-line (some states may even let you complete the application on-line). Here’s some basic information you’ll be expected to provide on your application:

  • Name, address, and phone number of the account owner
  • Name and address of your beneficiary
  • Social Security number (or tax ID number) for you and your beneficiary
  • Birth date and school grade of beneficiary
  • Relationship between you and your beneficiary
  • What is your funding schedule for the account?
  • Do you want to set up automatic payments?
  • Who will be the successor owner (in the event of your death)?

Designate a beneficiary

The beneficiary of the account is the person who will receive the plan benefits. Generally, prepaid tuition plans have stricter rules on who can be the beneficiary than college savings plans. For instance, prepaid tuition plans may limit the beneficiary choice to immediate family members or may set age limits that prevent you from naming a beneficiary who is beyond a certain age. Make sure to check the specific rules of the plan you’re considering.

Tip: If you want to change the beneficiary for any reason, you can. No taxes and penalties will be due if the new beneficiary is a family member of the original beneficiary. Section 529 of the Internal Revenue Code defines “family member” as children and their descendants; stepchildren; siblings; parents; stepparents; nieces; nephews; aunts; uncles; in-laws; and cousins. However, your particular prepaid tuition plan may be more restrictive.

Make a cash contribution

Whether you have a contract type of prepaid tuition plan or a unit type of prepaid tuition plan, at some point you’ll be contributing money to your account. Most prepaid tuition plans require that your account be fully funded within five years. In most states, you’re allowed to purchase up to five years’ worth of tuition credit.

Keep in mind that federal rules require all contributions to a prepaid tuition plan to be made in cash (or cash alternatives like checks). So if you have stock that you’d like to contribute, you must first sell it (which may result in a capital gain) and then contribute the proceeds.

Notify the plan administrator when you intend to start making withdrawals for college expenses

At some point before your child starts college, you typically must notify the plan administrator when you intend to start redeeming credits or making withdrawals from your prepaid tuition plan account. Check the rules of your specific plan for more details.

Continue to manage your account

Once your account is open, make sure to periodically review the plan’s overall rules from time to time. Also review your choice of beneficiary.

Tax considerations

Before you invest in a prepaid tuition plan, you should evaluate the federal and state tax consequences of plan contributions and withdrawals.

Income tax consequences for beneficiary (child)

Withdrawals (distributions) from a prepaid tuition plan used to pay the beneficiary’s qualified education expenses are completely income tax free at the federal level. (However, the beneficiary may owe state income tax, at his or her rate, on the earnings portion of such a withdrawal.)

If a withdrawal is not used for the beneficiary’s qualified education expenses (a nonqualified withdrawal) and the beneficiary receives the withdrawal, then the beneficiary will owe federal income tax (and probably state taxes, too) on the earnings portion. A 10 percent federal penalty will also apply (and possibly a state penalty).

Income tax consequences for account owner

If the account owner receives a withdrawal that is not used to pay the beneficiary’s qualified education expenses (in most cases where a nonqualified withdrawal is made, the account owner is the person who receives the distribution), then he or she will owe federal income tax (and probably state taxes, too) on the earnings portion. A 10 percent federal penalty will also apply (and possibly a state penalty).

Income tax deduction for plan contributions

There is no federal income tax deduction for contributions made to a prepaid tuition plan. However, states may offer a state income deduction for contributions. Most of the states that do provide a deduction impose a deduction cap, or limitation, on the amount of the deduction. Be sure to check the tax laws of your state.

Caution: If you plan to claim a state income tax deduction for your contributions, you should learn whether your state applies income recapture rules to prepaid tuition plans. Income recapture means that deductions allowed in one year may be required to be reported as taxable income in a subsequent year if you make a nonqualified withdrawal from the plan in that later year.

Interaction with education tax credits

You can claim the American Opportunity credit or the Lifetime Learning credit in the same year you withdraw funds from your prepaid tuition plan account to pay the beneficiary’s qualified education expenses. But your withdrawal will not be free of federal income tax if it applies to the same college expenses for which you’re claiming a credit. When you calculate the amount of the beneficiary’s qualified education expenses to determine the amount to withdraw from your prepaid plan, you must reduce the qualified education expenses by any expenses used to compute the credit.

Gift tax consequences for plan contributions

All contributions to a prepaid tuition plan are considered present interest gifts (as opposed to future or conditional gifts) to the beneficiary that qualify for the federal annual gift tax exclusion. This means that you can contribute up to $14,000 per calendar year to the account ($28,000 per year for married couples making joint gifts) without incurring federal gift and estate tax.

If your contribution is over $14,000 in a single year ($28,000 for joint gifts), there is a special election you can make to treat the contribution as if it were made evenly over a five-year period. You make the election on your federal gift tax return (Form 709), which you must file if your gift is over $14,000. The result is that you can gift up to $70,000 in one year ($140,000 for joint gifts)–reduced by any other gifts you make to the beneficiary in that year–and avoid federal gift and estate tax.

Example(s): Grandpa makes a $70,000 contribution in 2014 to his grandson’s prepaid tuition plan account. Grandpa files a federal gift tax return and makes the special election, which treats his gift as if it were made evenly over five years. The result is that Grandpa is considered to have made five annual contributions of $14,000 each in the years 2014 through 2018, and, if he makes no other gifts to the account in these years, no gift and estate tax is owed. In 2019, he can make another $70,000 contribution and make the special election again.

If you contribute more than $70,000 to your account ($140,000 for joint gifts), the averaging election applies only to the first $70,000 (or $140,000); the remainder is treated as a gift in the year the contribution is made.

Even if you are subject to gift and estate tax, you must first use up your applicable exclusion amount before you will actually pay any tax. The applicable exclusion amount allows you to pass a certain total amount of property free from federal gift and estate tax.

Finally, since state tax treatment may differ from federal tax treatment, check your state’s laws to see how your prepaid tuition plan contribution will be treated.

Gift tax consequences for contributions by grandparent

Grandparents need to keep the federal generation-skipping transfer (GST) tax in mind when contributing to a grandchild’s prepaid tuition plan account. The GST tax is imposed on transfers made during your life and at your death to someone who is more than one generation below you, like a grandchild. The GST tax is imposed in addition to, not instead of, federal gift and estate tax. Like the applicable exclusion amount, there is a lifetime GST tax exemption.

So, if you contribute $14,000 per year or less to your grandchild’s account during the calendar year ($28,000 for joint gifts), there are no federal transfer tax consequences–the gift qualifies for the annual federal gift tax exclusion, and it is also excluded for purposes of the GST tax.

If you contribute more than $14,000 ($28,000 for joint gifts) in a calendar year, you can elect to treat the contribution as if it were made evenly over a five-year period (as discussed above). Only the portion that causes a federal gift and estate tax will also result in a GST tax. But before you need to write a check for taxes owed, you must first use up your applicable exclusion amount and you can use your GST tax exemption.

Estate tax consequences for account owner

Contributions you make to a prepaid tuition plan aren’t usually considered part of your estate for federal tax purposes when you die, even though you retained control of the account (as account owner) during your lifetime. (Instead, the value of the account will be included in the estate of the beneficiary.) There is an exception to this general rule. When you (or any other contributor) make a contribution, elect to spread the gift over five years (as described above), and then die before the end of the five years, only the portion of the contribution allocated to the years after your death is included in your gross estate.

Example(s): Mom makes a $35,000 contribution to a prepaid tuition plan in Year 1 and elects to treat the gift as if it were made over five years. Under the election, Mom is considered to have made a gift of $7,000 each year ($35,000 divided by 5 years). She dies in Year 2. The result is that her total Year 1 and Year 2 contributions ($14,000) are not included in her estate. The remaining $21,000 ($35,000 – $14,000) is included in her gross estate.

As for the states, some states have an estate tax system like the federal estate tax, but many states calculate estate taxes differently. Check your state’s laws or talk with a tax professional.

Financial aid considerations

The federal government treats 529 plans (prepaid tuition plans and college savings plans) as assets of the parent for financial aid purposes if the parent is the account owner, if the student is the account owner, or if the plan was funded with UTMA/UGMA custodial account funds.

Questions & Answers

How long have 529 plans been around?

Section 529 plans, officially known as qualified tuition programs, or QTPs, were created by the federal government with the passage of the Small Business Job Protection Act of 1996, a piece of legislation that actually had little to do with college savings. These plans were later modified by the Taxpayer Relief Act of 1997, the Economic Growth and Tax Relief Reconciliation Act of 2001, and the Pension Protection Act of 2006.

Can you invest in any state’s 529 plan, or are you limited to your own state’s plan?

529 college savings plans are typically open to residents of any state, while 529 prepaid tuition plans are typically limited to state residents.

How do you know whether to choose a college savings plan or a prepaid tuition plan?

Your investment preferences and the college you think the beneficiary (let’s assume it’s your child) might attend will affect your choice.

A prepaid tuition plan generally guarantees you a minimum rate of return to ensure that you keep up with college inflation. Essentially, by contributing to such a plan, you lock in tomorrow’s tuition at today’s prices. This can certainly bring you peace of mind. However, if the stock market enjoys an extended period of high returns, you’ll generally still be limited to the return that your plan promises. And to receive the maximum benefits under a prepaid tuition plan, your child must attend a participating college. If your child chooses a different school, you may pay a penalty.

By contrast, a college savings plan doesn’t guarantee you any minimum rate of return. When you invest your money in a plan’s portfolio, you take your chances. If your portfolio earns a high rate of return, you’re entitled to all of it. But if it earns little or nothing (or even loses money), you may end up with less than you need to pay for your child’s education. The good news is that college savings plan funds can be used at any college that’s accredited by the U.S. Department of Education.

If you’re a fairly conservative investor and believe that your child will attend a specific college, then a prepaid tuition plan may be the appropriate choice. But if you don’t want to restrict your child’s college options or you believe that you can earn a better rate of return than what is promised by a prepaid tuition plan, then a college savings plan that offers a range of investment options may be the right choice.

Is there an age limit on who can be a beneficiary of a 529 plan?

There is no beneficiary age limit specified in Section 529, but a few states do impose one. You’ll need to check the requirements of each plan you’re considering. Also, some states may require that the account be open for a specified minimum length of time before funds can be withdrawn. Otherwise, a fee or penalty may be imposed. This is important if you expect to make withdrawals quickly because the beneficiary is close to college age.

Can you open a 529 account and name yourself as beneficiary?

Under many 529 plans, you can be both the owner and beneficiary of the account. This can be useful if you are older and plan to attend college in the future, or if you are planning for your future children. However, you may lose the estate tax benefits of a 529 plan by naming yourself as the designated beneficiary. And some plans don’t allow the owner and beneficiary to be the same person, so check the terms of the plan you’re considering.

Can you open a 529 account in anticipation of your future grandchild?

You can open an account before the birth of a child, though you have to go about it in a roundabout way.

First, you need to know the two key players involved in any 529 account. One is the account owner, who controls when the money is paid out and to whom. That may be you. (The account owner is usually the person who establishes the account and who puts money into the account.) The other key person is the designated beneficiary, who will use the money to pay for qualified education expenses. The account owner selects the designated beneficiary.

Since the person you want to name as the beneficiary is not yet born, you’ll need to take two steps. First, you’ll need to open an account and name a beneficiary who is a family member who will be related to your grandchild. Next, when your grandchild is born, you (the account owner) can change the beneficiary to your grandchild.

Check the details of each state’s plan carefully, because some plans impose age restrictions on the beneficiaries (such as being under age 21). That may pose a problem if you plan to name your adult son or daughter as the initial beneficiary. Other plans may require that the funds be spent within a certain time period, such as within 10 years of when the original beneficiary would be expected to enter college.

Can a non-U.S. citizen open a 529 account?

Yes, with a few limitations. Section 529 plan account applications generally ask for the Social Security number of the account owner and the beneficiary. If you will be the account owner and you don’t have a Social Security number, check with the administrator of the 529 plan before you send any money to see how you’ll be handled. Some 529 plans allow resident aliens to be the account owner, but normally these plans still require a Social Security number.

Another issue can be state residency. Some 529 plans require the account owner to be a resident of their particular state (for a certain time period) before an account can be opened. Alternatively, some plans require that either the owner or the beneficiary be a resident. So if the beneficiary is a resident, you may still be able to open an account even if you’re not a U.S. citizen or resident.

Can more than one account be opened for the same child?

Yes. You (or anyone else) can open multiple 529 accounts for the same beneficiary, as long as you do so under different 529 plans (college savings plan or prepaid tuition plan). For instance, you could open college savings plan accounts with State A and State B for the same beneficiary, or you could open a college savings plan account and a prepaid tuition plan account with State A for the same beneficiary. But you can’t open two college savings plan accounts in State A for the same beneficiary.

Also, keep in mind that if you do open multiple 529 accounts for the same beneficiary, each plan has a limit, and contributions can’t be made after the limit is reached. Some states consider the accounts in other states to determine if the limit has been reached. For these states, the total balance of all plans (in all states) cannot exceed the current year’s maximum contribution amount.

What happens if you open a 529 plan in one state and then move to a different state?

Most prepaid tuition plans require that either the owner or the beneficiary be a resident of the state operating the plan. So if you move to another state, you may have to cash in the prepaid tuition plan. And if you do cash in the plan, you will receive only your contributions (and possibly a low rate of interest).Alternatively, you can roll the assets over from your former state’s prepaid tuition plan to a new 529 plan (your new state’s prepaid tuition plan or a college savings plan) if both plans allow it. Check the details of each plan carefully before you start any transfers.

You can keep the same beneficiary when you do the rollover. The rollover does bring with it a restriction: You can roll the assets over from one 529 plan to another only once every 12 months. Some 529 plans also require a minimum time period, such as one year, before withdrawals (including rollovers) can be made from an account for any reason. Again, check both plans to make sure there are no withdrawal limitations.

You know you can borrow against your 401(k), but can you borrow against the value of your 529 account?

No. Section 529 plans do not allow loans against account assets.

Can you use the money in your 529 account as security if you apply for a loan?

No. According to IRS rules, a 529 account can’t be offered as collateral or security to get a loan from either the investment company managing the account or an outside bank or other financial institution.

Can the funds in a 529 plan be used for college expenses if your child is attending only part-time?

Ordinarily, yes. In most states, both part-time and full-time students can use 529 funds for qualified college expenses–check with the administrator of your plan.

Your child got a scholarship to college–now what?

If your child receives a college scholarship, you can withdraw–without penalty–funds in your 529 account equal to the amount of the scholarship. In each withdrawal from your 529 plan, you receive some earnings and some of the contributions that were made to the account. Generally, a penalty is imposed on the earnings portion of each withdrawal that you don’t use to pay qualified education expenses. Your child’s scholarship creates an exception–as long as your withdrawals during the year don’t exceed the amount of the scholarship, you will not owe a penalty. But you will owe federal and state income taxes on the earnings portion of each withdrawal.

Withdrawing the funds isn’t your only option. You can change the beneficiary of the prepaid tuition plan account. If the new beneficiary is “family member” of your child (as defined by Section 529 of the Internal Revenue Code), you won’t owe federal income taxes or a penalty when you make the change.

What happens to the funds in your 529 account if your child doesn’t go to college?

If your child decides not to go to college, you’ll have several options. First, you can leave the funds in the account. It’s possible that your child will change his or her mind about college at some point in the future. Just keep in mind that prepaid tuition plans generally require that you use the funds within 10 years (college savings plans usually allow you to keep the funds in the account indefinitely).

Second, you can change the beneficiary of the 529 account to another family member who will use the funds for college. And finally, you can withdraw the funds and use them for any purpose you choose. The drawback to this option, though, is that you will owe a 10 percent federal penalty tax on the earnings that have accumulated (a state penalty may apply as well). You will also owe federal and state income taxes on the earnings portion of your withdrawal.

What happens to your 529 plan if your child wants to postpone going to college for a year or two after high school?

A delay of one or two years shouldn’t matter, but if your child postpones college indefinitely, you should read the details of the 529 plan. Look to see if your plan has any time limits. Most prepaid tuition plans require that the funds in the plan be paid out within 10 years of the date the beneficiary is scheduled to attend college. College savings plans generally have no such requirement, and in most states, money in the account can be left indefinitely.

You intend to make tuition payments directly to your grandchild’s college, and you know this will reduce your estate. But would it be better to contribute to a 529 plan instead?

Direct payment of tuition to an educational institution is not considered a taxable gift. Therefore, you’re able to “give away” more than $14,000 per year for your grandchild’s college education and not worry about gift taxes. The money used to pay the tuition also will not be part of your estate.

With 529 plans, all contributions are considered gifts, so you want to use your federal annual gift tax exclusion. This exclusion lets you give to another person, like your grandchild, up to $14,000 per year without any gift tax or estate tax consequences. If you contribute more than $14,000 to the same beneficiary during a given year, though, you can avoid the gift tax if you elect to treat your contribution (up to $70,000) as if made evenly over a five-year period. However, informational gift tax returns must be filed. In any case, no gift tax must be paid out of pocket until you’ve used up your applicable exclusion amount.

Section 529 plans offer certain advantages over the direct payment of tuition. First, withdrawals from 529 plans can be used to pay for tuition, fees, books, and even room and board for college and graduate school. The exclusion for direct payment of educational expenses, on the other hand, applies only to tuition. Your grandchild might need significantly more financial assistance.

You should also consider the possibility that you may not live long enough to pay your grandchild’s tuition in the future. In such a case, nothing will be removed from your taxable estate (and the money your grandchild needs for education may not be available). If you contribute money to a 529 plan now, though, your contributions will be considered present interest gifts, and the value of your gifts to the plan will be taken out of your estate. (That is, unless your total gifts in one year are more than $14,000, you elect to treat the gifts as if made over a five-year period, and then you die within the five years. In such a case, the portion of the contribution allocated to the years after your death will be included in your gross estate.)

You’re putting money into a 529 plan for your grandchild. But are the assets subject to Medicaid spend-down requirements?

Very possibly. So far, state laws have largely ignored this issue. But unless future legislation in your state exempts 529 plans from Medicaid rules, you’d be wise to assume that these assets will be subject to the state’s grasp.

To be eligible for Medicaid, most states require that your assets and monthly income fall below certain limits. A state may count the assets and income that are legally available to you for paying bills. You can make assets unavailable by giving them away or by holding them in certain trusts. In some cases, though, such transfers may create a period of ineligibility before you can collect Medicaid.

The potential problem with 529 plans is that your contributions are “revocable.” This means that you can contribute money to your grandchild’s 529 account today, and then take it back (subject to income taxes and a penalty) later. Since it’s possible for you to get your hands on the money, your state Medicaid authorities may consider your 529 gift to be a countable asset when considering your eligibility for Medicaid. That might prevent or delay your eligibility for Medicaid.

In addition, your state has the right to “look back” at your finances 60 months from the date you apply for Medicaid. Contributions you’ve made to your grandchild’s 529 account within this period may delay your eligibility for Medicaid.

You may want to consult a Medicaid planning attorney and keep abreast of changes in your state’s laws with respect to Medicaid and 529 plans.

Can you transfer funds from your Coverdell ESA to a 529 plan?

Generally, yes. You may withdraw funds from your Coverdell ESA and not pay federal income taxes on the withdrawal if you use the funds for qualified education expenses. The rules for Coverdell ESAs consider a rollover contribution to a 529 plan (for the same person who is the beneficiary of the Coverdell ESA) as a qualified education expense. So, the transfer will usually be a nontaxable transfer from the Coverdell ESA to the 529 plan.

Can you transfer your child’s UTMA/UGMA custodial account to a 529 plan?

There are two ways to explore this rather tricky question. The first way is to examine whether it’s possible to liquidate an UTMA/UGMA account and invest the proceeds in a 529 plan. The second way is to see whether it’s possible to transfer existing UTMA/UGMA assets to a 529 plan.

One rule of UTMA/UGMA accounts is that the money be used for the child’s benefit. This requirement includes making an investment in a 529 plan (college savings plan or prepaid tuition plan), as long as the 529 plan has the same beneficiary as the custodial account. You can liquidate the investments in the UTMA/UGMA account and invest all of the proceeds in a 529 plan (though you may incur tax liability). The key is that the proceeds must be used for the benefit of the same beneficiary.

The question of keeping your child’s UTMA/UGMA account intact and transferring the assets to a 529 plan is more difficult. Whether this is allowed usually depends on the rules of the 529 plan. In either case–liquidating the UTMA/UGMA account or transferring the assets in the UTMA/UGMA account–there are important things to keep in mind.

First, federal law requires that all contributions to 529 plans be made in cash. Therefore, all assets in an UTMA/UGMA account would first need to be converted to cash if they were not already (e.g., stocks, real estate, certificates of deposit). So, even if the 529 plan accepts the transfer of assets, you will be required to turn those assets into cash. This may trigger income tax liability.

Second, because the cash will now be held within the UTMA/UGMA account, which, in turn, is in the 529 plan (sort of a cup within a bucket), you are still bound by the rules of UTMA/UGMA accounts. This means that you can’t change the beneficiary of the 529 plan, because gifts to an UTMA/UGMA account are considered irrevocable gifts to the beneficiary. In addition, you must relinquish control of the 529 plan to your child when he or she reaches the age of majority (18 or 21, depending on state law), because this is what happens with an UTMA/UGMA account. All future contributions you make to the 529 plan will be treated as UTMA/UGMA contributions, meaning that they will be considered irrevocable gifts to the beneficiary. And finally, some 529 plans might require that you name the child as the owner (as well as the beneficiary) of the 529 plan after UTMA/UGMA funds are contributed.

How do 529 plan fees and expenses compare to those associated with other savings alternatives?

Some 529 plans may charge high fees, but virtually all college savings options involve fees and expenses of some kind. It’s important to take fees and expenses into account when considering the ways to save for college because they can make a big difference in your total savings over time.

Your child will be going to college next year and using 529 funds to pay expenses–what do you need to do?

Now would be a good time to review the terms, conditions, and procedures of your 529 plan. Not all plans are alike. Don’t assume that the procedures your sister follows for her Iowa college savings plan will be the same for your Rhode Island college savings plan (or prepaid tuition plan). At a minimum, you should investigate the following issues.

First, bear in mind that you’ll probably have to notify the 529 plan administrator that your child will be making a withdrawal for college expenses. In most prepaid tuition plans, the payout procedures are standardized. For example, some prepaid tuition plans require that all plan withdrawals must occur within 10 years of the time the beneficiary starts college. College savings plan procedures can differ considerably from plan to plan, though. No matter what your plan, consider the following questions:

  • What education expenses does the plan consider “qualified”?
  • When must you notify the plan administrator that you wish to withdraw funds from the plan?
  • How do you document that the withdrawal has been used to pay qualified education expenses? How soon must you provide this documentation?
  • Are college expenses paid directly from the plan to the educational institution, or is the beneficiary reimbursed for expenses? How long will reimbursement take?
  • Is a minimum withdrawal amount required, or is there a limit on the number of withdrawals per semester?
  • Does the state’s definition of “eligible educational institution” differ from the federal definition, and does your child’s college satisfy the definition?
  • Does the plan require a minimum level of attendance (e.g., half-time enrollment) for qualified expenses other than room and board?

Second, make sure you understand how a qualified withdrawal from a 529 plan will affect your child’s state income taxes. Some states exempt a plan’s earnings from income tax if used to pay qualified education expenses. Other states tax the earnings.

Third, explore how a withdrawal from a 529 plan will affect your child’s eligibility for financial aid from the college as well as federal financial aid.

Finally, investigate how to coordinate a 529 plan withdrawal with the American Opportunity credit and Lifetime Learning credit to maximize the tax benefit. Although you may claim one of these education tax credits in the same year you withdraw funds from a 529 plan, for your 529 plan withdrawal to be tax free at the federal level, you may not use the same underlying education expenses to qualify for the tax credit.

 

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.

The information provided is not intended to be a substitute for specific individualized tax planning or legal advice. We suggest that you consult with a qualified tax or legal advisor.

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