As the cost of education continues to increase, funding a 529 Plan can provide invaluable investment and gifting opportunities for education-focused families. Cash gifts to 529 Plans grow income tax deferred if used for qualified education expenses. Contributions to a 529 Plan allow a donor (often a parent or grandparent) to reduce the size of the donor’s taxable estate (the amount subject to federal and state estate tax) while also transferring wealth to the next generation for educational purposes. Further, the donor typically retains the right to control distributions from the account, decreasing the risk that the beneficiary would use the account for purposes other than education.
Income Tax Repercussions
Beneficiaries of 529 Plans, as well as those contributing to such plans, should be mindful of the restrictions inherent to such accounts – including, but not limited to, the income tax consequences if 529 Plan accounts are used for nonqualified expenses. This situation may occur when parents expect to pay for a full four years of private college and have excess amounts in a 529 account because their child decides not to attend college, attends an in-state public school or receives unanticipated financial aid or scholarships.
Distributions from a 529 account (also known as a qualified tuition plan or QTP) are subject to federal income tax unless the distribution is a “qualified distribution.”1 Qualified expenses include tuition, fees, books and other items required for the enrollment or attendance of the beneficiary at an eligible educational institution.2 While most donors anticipate that QTP will be used for higher education, up to $10,000 can be used on certain educational expenses for children in grades K-12.
Distributions from a 529 Plan for a nonqualified expense, such as a wedding, an automobile purchase, or a down payment on a home, would subject the earnings (i.e., growth) portion of the nonqualified distribution to both federal and state income tax, as well as a 10% tax penalty. Additionally, if a state income tax deduction is allowed for contributions to a 529 Plan (Massachusetts allows such a deduction up to $1,000 per donor or $2,000 for a married couple annually) a “clawback” from the state may apply if funds are later used for nonqualified expenses.3
Because income tax liability on withdrawals for nonqualified expenses attaches to the party making the withdrawal, each individual transaction must be considered.
Alternate Action
To avoid taxes and penalties on 529 Plan withdrawals, account custodians may wish to consider an alternate use for unused account balances, including but not limited to the following:
- Continuing to hold funds in the 529 Plan if it appears likely that the beneficiary will have qualified educational expenses in the future
- Purchasing computer equipment for the beneficiary for educational purposes
- Rolling over funds to a 529 account for a relative of the beneficiary, including but not limited to immediate family members, step-siblings, first cousins, and aunts/uncles
- Rolling over funds to a Roth IRA account for the beneficiary (subject to certain restrictions and requirements that must be carefully observed)
- Paying off the beneficiary’s student loans up to $10,000 through unused 529 funds
Conclusion
529 Plans allow individuals to invest in their family’s future while also minimizing estate tax and ensuring that the funds are used properly. Understanding the structure of this wealth planning strategy – as well as other planning options, such as establishing irrevocable trusts for the benefit of younger family members – is crucial to leveraging the benefits of different planning strategies effectively and avoiding pitfalls, including, but not limited to, otherwise avoidable income tax.
For a customized strategy carefully tailored to meet your family’s needs, contact the attorneys in our Private Client Services practice at Wilchins Cosentino & Novins LLP.
Attorney Mary G. Wilson concentrates her practice on the areas of estate planning, business succession planning, estate and trust administration, wealth transfer, legacy planning and gift and estate tax planning.
This article is not legal advice and should not be taken as such or relied upon as legal advice.