The Gift of Knowledge: Tax implications of giving through 529 plans (qualified tuition plans)
Funding a child’s qualified tuition plan for holidays and birthdays can have tax effects
H&R Block Tax Professionals, click to login to the Tax Research Center:
- May an individual who is a resident of one state contribute to a 529 plan (QTP) in another state?
- Guidance on PATH Act and TCJA Changes to 529 Plans
- How does a 529 plan (QTP) operate?
- How do the gift tax rules apply to 529 plan contributions (QTP contributions)?
- How does a taxpayer determine the taxable portion of a 529 plan distribution (QTP distribution)?
- Is there a penalty for a distribution from a 529 plan (QTP)?
- What are qualifying education expenses (QEEs)?
Whether it’s opening a 529 plan, sometimes known as a qualified tuition plan (QTP), or contributing to one year after year, family and friends who wish to help save for a child’s K-12 or college expenses need to know the tax implications when they make a gift.
For more information on how the Tax Cuts and Jobs Act of 2017 affected 529 plans, including the $10,000 annual distribution limit for K-12 expenses, see “Parents of K-12 students face state-tax uncertainties under new 529 plan rules.”
What is a 529 plan?
A 529 plan allows a taxpayer to either prepay or contribute to an account established solely for paying a student's qualified education expenses at an eligible educational institution. 529 plans can be established and maintained by states (or agencies or instrumentalities of a state) and eligible educational institutions. The program must meet certain requirements to qualify as a 529 plan; it’s not enough to just open a savings account for tuition.
What expenses can the funds be used for?
Generally, qualified education expenses (QEE) are expenses required for the enrollment or attendance of the designated beneficiary at an eligible educational institution. Qualified education expenses also include reasonable room and board, which many other education tax benefits do not account for.
Eligible educational institutions include public and nonprofit colleges, universities, and vocational schools eligible to participate in federal student aid programs. Eligible institutions are usually listed on the Federal Student Aid Code Search or taxpayers can contact the institution to determine whether it qualifies. The designated beneficiary is generally the student (or future student) for whom the 529 plan is intended to provide benefits.
Expenses, such as tuition, enrollment fees, university athletic fees, lab fees, and books are all considered QEE when determining the taxability of a 529 plan. Additionally, a taxpayer may use expenses for rent, utilities, and food while attending an eligible institution as QEE, if those expenses do not exceed the typical room and board expenses listed on the school’s website.
What is a 529 savings plan?
A 529 savings or investment plan allows taxpayers to save money for K-12 education costs or college, on behalf of a designated beneficiary, who can be a child or adult learner. Contributions to the account and any investment earnings it generates can be used to pay for the beneficiary's qualified education expenses, including books and related education costs outside of tuition.
If the beneficiary's education plans change, investors can change the beneficiary, or withdraw the funds in the account as a nonqualified distribution.
A qualified distribution means the funds are used for qualified education expenses. When using the plan for K-12 education, a taxpayer may use up to $10,000 per year for a student’s qualified education expenses. Therefore, a taxpayer may pay for that child’s private school tuition for K-12 education up to $10,000 per year without paying tax on the earnings. There is no ceiling on the amount of qualified education expenses for post-secondary expenses.
A nonqualified distribution means the funds are not used for higher education expenses. In that scenario, the earnings in the account, but not contributions, are subject to state and federal tax plus a 10 percent federal tax penalty. In some cases, only part of a distribution is qualified.
Example 1: Miranda’s parents funded a 529 plan for her and contributed $25,000 over the years. However, Miranda never used any of the funds for higher education because she decided not to go to college. The total balance in the account was $35,000 when her parents closed the account and distributed all the funds. There were no qualified education expenses in the year of the $35,000 distribution from the 529 plan. The portion of the distribution attributable to account earnings ($10,000) is subject to income tax, and the $10,000 earnings are subject to a 10 percent penalty.
What's a prepaid 529 tuition plan?
The other popular college savings vehicle, called “prepaid tuition plans,” allows taxpayers to purchase tuition for a student at current rates, even if the student will not attend college for several years. Timing and age is a crucial factor with prepaid tuition plans, because most require plan participation for at least three years before funds can be used, and that the beneficiary be 15 years old or younger at the time of account inception.
The prepaid tuition program itself pays future college tuition at any of the state's eligible colleges or universities - or it offers cost-weighted payment to private or out-of-state institutions. The program does this by pooling and investing the plan's funds, allowing it to make enough money to exceed the pace of rising state college tuition. Essentially, a taxpayer is loaning their money to the state's plan in return for the locked-in tuition rate. Tuition can be purchased in monthly installments or in a lump-sum.
It is important to note, however, that prepaid plans are often only of value if the taxpayer is certain the student will attend an in-state school. While most of the plans do allow funds to be used for out-of-state college tuition, there is often an accompanying penalty, either in the form of a fee or weighted payment based on the state's tuition rates.
Not all states offer prepaid tuition plans. Taxpayers considering setting up a prepaid tuition plan should check current availability in their state.
Tax effects can vary
No deduction on a federal return but some states do allow a deduction
Contributions to a 529 plan are not deductible on a taxpayer’s federal tax return. However, if a taxpayer lives in any of the following listed states, their state will often allow a deduction (limits and eligibility on the state tax benefit vary from state to state) on their state tax return for a contribution to a 529 plan:
Alabama, Arkansas, Arizona, Colorado, Connecticut, D.C., Georgia, Idaho, Illinois, Indiana, Iowa, Kansas, Louisiana, Maryland, Massachusetts, Minnesota, Michigan, Mississippi, Missouri, Montana, Nebraska, New Mexico, New York, North Dakota, Ohio, Oklahoma, Oregon, Pennsylvania, Rhode Island, South Carolina, Utah, Virginia, Vermont, West Virginia, and Wisconsin.
Gift tax implications
There is no tax limit to the amount a taxpayer can contribute to a 529 plan, although plans usually have an account maximum. Gifts of less than $15,000 (for 2018 and 2019) in a tax year per each gift giver (and receiver), are not taxable through the gift tax rules. If a taxpayer does want to give over $15,000 in a year, there is a special rule to treat a gift as though it is given over a period of five years. A taxpayer should consult with a tax professional if they decide to give more than the annual gift tax limit.
Generally, distributions from a qualified tuition plan are not taxable, provided they are used for qualified education expenses. The amount that was originally contributed to the account will not be included in the beneficiary’s taxable income. The amount that the account earned in interest also will not be included in income, provided the full amount of the distribution is used for things like tuition, books, supplies and equipment, as well as reasonable costs for housing required for enrollment or attendance.
Ten percent penalty
If a taxpayer chooses to take a distribution from a 529 plan and the funds are not used to pay for qualified education expenses, then not only are those earnings taxable, they are also subject to a 10 percent penalty. However, if a student earns enough scholarship money to pay for their education, they are exempt from paying the penalty on distributions from a 529 plan that equal the amount of the scholarships. They are still required to pay tax on the earnings but do not have to pay the 10 percent penalty.
Similarly, a taxpayer can take a distribution from a 529 plan and claim an education credit (the American Opportunity Tax Credit or the lifetime learning credit) in the same year. However, the taxpayer can’t use the same education expenses to take a tax-free distribution from a 529 plan and an education credit. If a taxpayer uses both education benefits, part of the 529 plan distribution attributable to earnings may be taxable, but any distribution included in income because of the credit is not subject to the 10 percent tax.
Example 2: Emily’s parents funded a 529 plan for her and contributed $20,000 over the years. The total balance in the account was $30,000 on the date a distribution of $6,000 was made for Emily’s first semester of college expenses. Emily had $8,000 of qualified education expenses (QEE) for the tax year. She received a tax-free merit scholarship of $3,000. In addition, Emily’s parents chose to claim an American Opportunity Tax Credit (AOTC) of $2,500 (the maximum amount of the credit based on $4,000 of qualifying education expenses).
Emily’s adjusted qualified education expenses (AQEE) are $1,000 ($8,000 QEE − $3,000 tax-free scholarship − $4,000 expenses used to claim the AOTC).
Because the 529 distribution is more than the AQEE, part of the earnings will be taxable. Box 2 of Emily’s Form 1099-Q shows $1,000 earnings. Emily calculates the taxable part of the distributed earnings as follows:
- $1,000 (earnings) × $1,000 AQEE/$6,000 distribution = $167 tax-free earnings
- $1,000 (earnings) − $167 (tax-free earnings) = $833 taxable earnings
The part of a 529 plan distribution representing the amount paid or contributed to the plan is not taxable. This is a return of the investment in the plan. However, Emily must include $833 of earnings in income on Form 1040, Schedule 1, line 21. The distribution is not subject to the 10 percent penalty because one exception to the penalty rules is for distributions that become taxable income for Emily when she receives a tax-free scholarship and her parents claim the American Opportunity Tax Credit.
Transferring the account: 529 plan rollovers and beneficiary changes
If the child ends up not going to college, or not using all the funds in the account, the designated beneficiary can be changed to a member of the beneficiary’s family, such as a sibling, without transferring accounts. There are no income tax consequences.
Additionally, a taxpayer can contribute to a 529 plan for their child and then if the child does not use up all the funds, the designated beneficiary may make one of their own children the beneficiary.
There are many options for education-related tax savings under the Internal Revenue Code, and 529 plans are among the best options for taxpayers. While 529 plans often require a bit of pre-planning, they can be extremely advantageous for both the taxpayer setting up the plan and the beneficiary.
More information from the H&R Block Tax Information Center: