What Is a 529 Plan Continued
August 5th, 2005
What are the tax advantages of 529 plans?
529 plans account balances grow tax deferred. Distributions from 529 plans for qualified educational expenses are federal income tax-free until 2011. They may be subject to state income tax. Distributions not for qualified educational expenses are subject to ordinary income tax plus a 10% penalty (paid by the beneficiary).
Special gift tax treatement of 529 plans
529 Plans receive special gift tax treatment. For gifts over $12,000 (beginning in 2006), the IRS allows an individual to treat the gift as if he/she made the gift in equal amounts over five years to avoid gift taxes occurring on funds contributed into 529 plans. As a result, the individual can give $60,000 ($12,000 x 5 years) or a couple can give $120,000 ($24,000 x 5 years) in one year without gift taxes on funds going into 529 plans. The individual, in essence, is getting an advance for future years’ annual exclusions of gift taxes. If you contribute more than $12,000 in one year, you must file Form 709 (the gift tax return).
The contributor and beneficiary of the 529 Plan must not have any control over the investment of the contributions of the 529 Plan. Because of this restriction, states choose the investment manager, usually an investment company or the state treasurer and the plan’s asset allocation, which is typically quite conservative.
The contributor can establish an account or a 529 Plan for anyone, including him or herself. There are no age restrictions. In addition, the contributor can change the beneficiary of the 529 Plan, and there is no income tax implication if the new beneficiary is a member of the same “family” as the prior beneficiary.
A change in the designated beneficiary of the 529 Plan or a rollover to the account of a new beneficiary, is subject to gift and generation skipping taxes unless the new beneficiary is:
(1) of the same generation as, or a higher generation than, the old beneficiary and
(2) a member of the old beneficiary’s family.
As long as a state follows these general rules, it may add other benefits of investing in 529 plans. For example, some states allow contributors to deduct the amount of their contributions on their state tax returns and/or have distributions free of state income taxes.
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