In Part 1, we talked about two things that can influence how and in whose name it makes sense to save money for college: the Kiddie Tax, and how college need-based financial aid treats assets depending upon who the owner is.

Now in Part 2, we’ll examine 529 Plans more closely.

As most know, 529 Plans can be funded by anyone with up to the gift tax annual exclusion amount per year ($15,000), although that limit is included in the total annual gifting amount – not in addition to. You can even “front-load” a 529 by as much as five times that amount – $75,000 – and still have it qualify for the annual gift tax exclusion. But (1) it reduces your gift tax exclusion for that student in subsequent years by $15,000 until that excess first year contribution is absorbed, and (2) until absorbed, the excess contribution is still includible in the donor’s taxable estate. There are also aggregate lifetime limits that vary per state – the maximum account balance in Massachusetts is $400,000. The assets grow tax-free within the Plan.

Withdrawals from 529 Plans for Qualified Education Expenses are tax-free. So unlike retirement plans, growth in these plans is not merely tax-deferred; they are tax free. However, if withdrawals are not for Qualified Education Expenses, income tax does apply and there is a 10% penalty. There is the option to switch the beneficiary to another person if the initial beneficiary does not go to college, but the option is not limitless. Investment options are also limited, although for most people that is not a very serious concern.

What are Qualified Education Expenses? (1) Tuition and fees at accredited institutions, whether the student is full or part time. (2) Room and Board. (3) Books and supplies (even basics like pen and paper). (4) Techie items like computers, software, and internet service.

What are not Qualified Education Expenses? Anything else. But it is important to note a few things in particular that are not Qualified Education Expenses: (1) Transportation and travel. (2) Student loan repayments, even for items like tuition that do qualify as Qualified Education Expenses. (3) General electronics, cell phones, and cell phone service. (4) Fitness club memberships. (5) Health Insurance, even through the college.

The 2017 Tax Act improved 529 Plans by allowing a limited amount to be spent on tuition – and only tuition – for elementary through high school tuition. This kind of expenditure is limited to $10,000 per year. But the sooner the funds are spent (e.g., elementary school), the less useful the tax-free growth.

Now the big question: how are 529 Plans treated for need-based college financial aid?

A student-owned or parent-owned (or if divorced, custodial-parent owned) 529 Plan is treated as an asset of the parent. That is, it is subject to the maximum 5.64% reduction rule we discussed in Part 1. Distributions from the 529 for Qualified Education Expenses are ignored and not treated as income.

A 529 Plan for the student owned by anyone else (like a grandparent) is ignored as an asset. So far so good, and this is sounding like a great approach. But here is the bad part. Any distributions from the 529 Plan are treated as untaxed income to the student, and can reduce the student’s need-based financial aid by up to half of the amount distributed! Ouch! That’s way worse than the 5.64% reduction if it were treated as a parental asset.

And this is also true of any gifts from the grandparents to the student, whether a cash gift or a gift by paying the tuition directly … it is considered untaxed income that can reduce financial aid by 50% of the gift. (Note that a gift by direct payment of tuition is not subject to any gift tax and is not limited to $15,000 per year, but this advantage is only of interest to the very wealthy.)

In Part 3, we’ll consider how a combination of 529 Plans and Trusts might be a good approach for some.

Special Needs Law Group of Massachusetts can advise you on creating an estate plan that fits your unique circumstances and may include funding a college education. Learn more about Special Needs Law Group of Massachusetts here.

This blog post does not constitute legal or tax advice, even if you are presently a client of Special Needs Law Group of Massachusetts, PC, nor is an attorney-client relationship created by reading it. If you want legal or tax advice, you should retain a licensed attorney or tax advisor for that purpose.