by: Susan Hagley, MST
Senior Wealth Strategist

The cost of education is notoriously high, leaving some families wondering about the best strategy to save for these expenses. 529 plans have long been a popular education savings vehicle. Unlike a traditional investment savings account, contributions grow tax-free and withdrawals are tax-free when used for qualified education expenses.

But 529 plans also came with significant drawbacks to consider, including tax and penalties on ineligible expenses and restrictions on leftover funds. These drawbacks created uncertainty about how much to fund a 529 plan and what happens to unused funds. After all, there are many circumstances which may not be anticipated, such as scholarships, public vs. private school or the beneficiary of the account deciding not to go to college.

In recent years, however, changes to federal tax law have significantly improved the flexibility of 529 plans, making them an even more attractive option for families to save for education expenses. This article will discuss how to take advantage of these new rules.

The Basics

A 529 plan is a tax-advantaged savings plan designed to help families save for future education expenses. Contributions to a 529 plan grow tax-free, and withdrawals used for qualified education expenses are also tax-free at the federal level. Some states offer additional tax benefits, such as deductions or credits for contributions.

Funds from a 529 plan can be used for qualified education expenses at eligible institutions, including four-year colleges and universities, community colleges, trade, technical and vocational schools, both in the United States and abroad. If funds from a 529 plan are withdrawn for non-qualified expenses, the earnings portion of the withdrawal may be subject to income tax and a 10% penalty.

The student is the beneficiary of the 529 account and not the owner. The parent, or whoever sets up the account, is the owner and ultimately controls the distribution of the money. If the student does not use any or all of the funds, the remaining funds will remain under the owner’s control. One option for the owner is to transfer all or part of the unused funds to a 529 plan for another child or qualified family member.

529 plans offer flexibility in terms of who can contribute, how much can be contributed and how the funds can be used. There are no income limits for contributing to a 529 plan, and contributions can be made by anyone, not just the account owner. Aggregate contribution limits vary depending on the state but range from $235,000 to over $560,000.

Recent Changes

In recent years, there have been significant changes in the federal law governing 529 plans. It’s important to make sure that the state in which your plan is governed has also adopted the same law.

In 2017, the Tax Cuts and Jobs Act expanded 529 plans to include tuition at K-12 schools. Previously, 529 plans were reserved for postsecondary education expenses. Now, owners can make tax-free withdrawals from a 529 account to pay for tuition at K-12 schools. These withdrawals are limited to $10,000 per year per child.

In 2019, there were changes to 529 rules under the SECURE Act to expand the definition of qualified expenses. First, 529 account proceeds can now be used to pay off some student loan debt for the account beneficiary and their siblings. This is limited to a lifetime maximum of $10,000 per individual. Keep in mind that if you make a student loan payment with a distribution, you cannot then claim a student loan interest deduction.

In addition, under the SECURE Act, 529 funds can now be used to pay for the fees, books, supplies and equipment required to participate in an apprenticeship program that is registered and certified with the U.S. Secretary of Labor. This change broadens the scope of eligible institutions, which reduces the risk that your 529 savings will not be utilized if the student decides to pursue a vocational program.

The CARES Act of 2021 included an update to streamline how financial aid is determined and administered. One significant change is that the FAFSA (Free Application for Federal Student Aid) no longer requires students to report distributions from a 529 plan owned by a non-parental figure such as a grandparent. Previously, these distributions were considered untaxed income to the student and had to be reported on the FAFSA. This change removed the so-called “grandparent trap” and improves the student’s eligibility for financial aid.

Finally, in 2022, the SECURE 2.0 Act includes a provision allowing tax-free rollovers from 529 plans to a Roth IRA for the beneficiary effective in January 2024. Previously, the remaining 529 plan funds could only be used by another related beneficiary or withdrawn by the original beneficiary subject to a 10% penalty and income tax on the investment gain.

There are several important limitations to keep in mind under the SECURE 2.0 Act:

• The Roth account must be in the 529 plan beneficiary’s name (not the owner, if different).
• To prevent funding a 529 account for the purpose of immediately transferring the funds to a Roth IRA, the 529 plan account must have been in existence for a minimum of 15 years before rolling the funds to a Roth account. (More guidance is expected from the IRS as to whether a change in 529 beneficiary triggers a new 15-year time period.) In addition, contributions and earnings made within the last five years cannot roll over to a Roth account.
• The maximum lifetime Roth rollover amount is $35,000 per beneficiary. This amount is not indexed for inflation. (More guidance is expected from the IRS as to whether this limitation also applies to 529 account owners.)
• The Roth rollover is also limited to the annual Roth IRA limit. For example, the 2024 IRA contribution limit is $7,000 per year for individuals under age 50. In addition, the amount eligible for rollover is reduced by any IRA contributions made that year.
• The beneficiary must qualify for making a Roth contribution for the year by having compensation at least equal to the amount being rolled over. Though, interestingly, the AGI limitations do not apply.

Estate Planning with 529 Plans

Funding education expenses through a 529 plan can be a meaningful way for wealthy families to leave a legacy and support the educational goals of future generations. By earmarking funds specifically for education, families can ensure that their wealth has a lasting impact on the academic success and opportunities of their descendants.

Contributions to a 529 plan qualify for the annual gift tax exclusion, which allows donors to gift up to a certain amount per beneficiary each year without triggering gift tax consequences. As of 2024, this exclusion amount is $18,000 per year per beneficiary.

Additionally, donors can elect to treat 529 plan contributions of up to five times the annual exclusion amount ($90,000 for an individual or $180,000 for married couples) as if they were made over a five-year period without utilizing gift tax exemption.

While the donor retains control of the 529 plan assets, they can also desaignate a successor account owner and change the beneficiary if needed. This allows for flexibility in estate planning strategies and the ability to adapt to changing circumstances or preferences.

Alternatives to 529 Plans

While this article focuses on 529 plans and recent changes made to federal law, there are alternative strategies which may be used in conjunction with, or instead of, a 529 plan. Some examples include an investment account, Roth IRA, UGMA/UTMA, direct tuition payments, and a trust. Each option has its own set of benefits and limitations to consider.

One notable alternative for wealthy families is direct tuition payments. Tuition payments made directly to the educational institution are not treated as taxable gifts, so tuition can be paid without using any annual exclusion or the gift tax exemption. This rule generally does not extend to payments for other expenses, such as room and board.

Another alternative is a Gift Trust, which may be set up for a single beneficiary or as a multigenerational trust. A Gift Trust does not offer the income tax advantages of a 529 plan. There is however, more flexibility in how you can draft a Gift Trust to meet your goals and objectives. Unlike a 529 plan, there is no limit on the aggregate amount which may be gifted to the trust, there is more flexibility in making investment decisions and there are less restrictions on the use of the assets gifted. A Gift Trust could be funded with annual exclusion gifts and/or a gift utilizing your exemptions. The current gift/estate and GST exemption levels of $13,610,000 are historically high and set to return to previous levels on December 31, 2025. This may be an opportunity to use some of your exemptions before they are reduced.

Conclusion

529 plans have long been an attractive way to save for daunting college costs. Recent legislation has amplified their versatility and reduced uncertainty around 529 plan funds. Owners now have more control and flexibility over the disposition of the funds, including new options for the use of unused funds. Further guidance from the IRS may clarify or change the interpretation of new legislation. Your Oxford team of advisors partner with your tax and legal advisors to implement the optimal strategy.

The information contained in this report is confidential and proprietary to Oxford and is provided solely for use by Oxford clients and prospective clients. The opinions expressed are those of Oxford Financial Group, Ltd. The opinions are as of date of publication and are subject to change due to changes in the market or economic conditions and may not necessarily come to pass. The information in this presentation is for educational and illustrative purposes only and does not constitute investment, tax or legal advice. Tax and legal counsel should be engaged before taking any action. OFG-24005-2