[author: Beth S. Cohn]

As higher education costs continue to escalate, parents or grandparents may look to different savings vehicles for their children’s college fund.  The IRS, under section 529, provides parents with the opportunity for a higher education savings plan.

There are two sets of tax rules for 529 plans (the “Plan”).  One relates to the income taxation of the owner and the beneficiary of the Plan, while the other relates to gift tax consequences of making a contribution and/or changing beneficiaries. It is important to take advantage of contributions, gain on investments and beneficiary flexibility to enjoy the maximum benefits from a 529 plan.

Contribution Limits and Eligibility for Use of Funds

There are no specific contribution limits or age limits for the use of funds; however, the amount contributed must be used by the beneficiary for "qualified higher education expenses”.  The IRS defines qualified expenses to include tuition, books, supplies, fees and required equipment. Reasonable room and board is also a qualified expense if the student is enrolled at least half-time.  Eligible schools include colleges, universities, vocational schools, or other post-secondary schools eligible to participate in a student aid program of the Department of Education. This is a very broad definition and includes nearly all accredited public, nonprofit, and proprietary (for-profit) post-secondary institutions. A school knows whether or not it qualifies and can provide that information to potential students.  To be qualified, the Plan needs to have safeguards that prevent contributions for a beneficiary in excess of the amount necessary to fund qualified higher education expenses for the beneficiary.

Income Tax Consequences of Contributions and Distributions

Contributions made to a 529 plan are not deductible from income taxes.   However, accrued earnings in the plan are tax free.  Distributions to a beneficiary generally do not have to be included as gross income to the beneficiary, if the distribution is less than or equal to qualified higher education expenses.   If there are distributions made in excess of the amount used by the beneficiary to pay qualified higher education expenses then those distributions are included in gross income of the beneficiary.  If there are earnings in the excess distribution, then they are also subject to a 10% penalty. 

Gift tax Consequences of the Contribution

A contribution to a 529 plan is treated like a gift from the owner of the Plan to the Beneficiary.  The annual gift tax exclusion applies, which in 2012 is $13,000 per donee per year.  The gift tax exclusion may be adjusted by the IRS annually.  If the amount put in to the 529 Plan exceeds the annual exclusion for a given year, the excess amount can be applied against the annual exclusion ratably over 5 years.  This functions like a carryover, and an election has to be made.  In any tax year that an amount is carried over, the total annual exclusion, including the carried over amount, cannot exceed the annual exclusion limit.  If no other gifts are given to the beneficiary, the total amount that can be placed into a 529 Plan and qualify for the annual gift tax exclusion over 5 years is $65,000.  The owner will need to file a gift tax return and use part of their lifetime exemption if the contributions exceed the annual gift tax exclusion.

Change of Beneficiaries

In the event that the child (beneficiary) does not use all of the funds for qualified higher education expenses, then the beneficiary of the 529 Plan can be changed.   The new beneficiary has to be a family member of the old beneficiary to avoid adverse tax consequences for the beneficiary change.  This provides much needed flexibility in the event that the original designated beneficiary does not attend college or receives a full scholarship.  Another child can be named as long as the child is a member of the family.  If funds remain in the 529 Plan after a beneficiary has finished school, a younger child can be named beneficiary of the Plan.   There may also be gift tax consequences on the change of the beneficiary.  The IRS currently defines Members of the beneficiary's family as follows.

“For these purposes, the beneficiary's family includes the beneficiary's spouse and the following other relatives of the beneficiary

1. Son, daughter, stepchild, foster child, adopted child, or a descendant of any of them.
2. Brother, sister, stepbrother, or stepsister.
3. Father or mother or ancestor of either.
4. Stepfather or stepmother.
5. Son or daughter of a brother or sister.
6. Brother or sister of father or mother.
7. Son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, or sister-in-law.
8. The spouse of any individual listed above.
9. First cousin.”

Source: http://www.irs.gov/publications/p970/ch08.html#en_US_2011_publink1000178575

This is a general overview of the IRS rules on Section 529 plans.   It is not an exhaustive analysis.  These rules are very complicated, and we recommend that you consult a tax professional before establishing a 529 plan.

About the author: Beth S. Cohn is a shareholder at the Phoenix law firm of Jaburg Wilk where she assists clients with business, tax, gifting programs, succession planning, asset protection and estate planning. She chairs the business law department and is a State Bar of Arizona certified tax specialist and a CPA. Beth can be reached at bsc@jaburgwilk.com or 602.248.1030.

IRS CIRCULAR 230 DISCLOSURE: To ensure compliance with requirements imposed by the IRS, we inform you that, to the extent this communication addresses any tax matter, it was not written to be and may not be relied upon to (i) avoid tax-related penalties under the Internal Revenue Code, or (ii) promote, market or recommend to another party any transaction or matter addressed herein.