Financial Planning

If you ask Americans to name their most pressing financial concern, the answer for most will be having enough money for a comfortable retirement. Number two on many people’s list, however, is funding their children’s and/or grandchildren’s education. There are many savings and investment vehicles to help:

• Prepaid tuition plans under IRC 529
• Education savings plans under IRC 529
• Coverdell education savings accounts (formerly referred to as education IRAs)
• Custodial accounts
• IRC 2503(c) trusts
• Lifetime Learning Credits
• Financial Aid

Of all your options, 529 plans are perhaps the most advantageous. The Pension Protection Act of 2006 enhanced the tax benefits of 529 college savings plans, which are now afforded a 100% federal tax exemption on all plan earnings. Today, 529 plans have been established in all 50 states and Washington, DC. But saving for education still requires a well-thought-out strategy that considers the income and estate tax ramifications of all possible education funding alternatives. 

Contributions to a 529 plan must be made in cash and are made with after-tax dollars. Every 529 plan has certain contribution limits that are mandated by both state law and the Internal Revenue Code. These are basically designed to prevent contributions on behalf of a beneficiary from exceeding the amount necessary to provide for their education expenses. Each plan, however, can interpret these limitations differently, and all have contribution limits of at least $235,000. 

The earnings on funds held in state-sponsored 529 accounts are not subject to income tax upon liquidation if the funds are used to pay for qualified higher education costs of the beneficiary.

This favorable income tax treatment is only available for qualified higher education expenses incurred at an eligible educational institution, with a $10,000 exception for withdrawals for K-12 education expenses. For 529 purposes, qualified higher education expenses include:

• Tuition
• Fees
• Room and board (subject to certain limitations)
• Books, supplies, and equipment

Withdrawals from a 529 plan that are not used for the beneficiary’s qualified higher education costs will be subject to ordinary income taxes as well as a 10% penalty. The penalty does not apply in the event of the death or disability of the beneficiary, if the beneficiary attends a U.S. military academy, or to the extent that the beneficiary receives a scholarship. Because of the 10% penalty on nonqualified withdrawals, a 529 plan is not appropriate as a tax deferral vehicle if it’s not used for education.

Despite potential withdrawal penalties, some donors find the ability to take back the funds an attractive benefit of 529 plan accounts—especially compared to custodial accounts or a Coverdell education savings account, where the funds irrevocably belong to the minor beneficiary. 

As the account owner, the donor has the power to change the designated beneficiary of the 529 account at any time. However, if the new beneficiary is not a member of the family of the old beneficiary, the transfer is considered a nonqualified withdrawal. For this purpose, family includes any descendant, stepchild, sibling, stepsibling, parent or ancestor of parent, niece or nephew, aunt or uncle, or first cousin, as well as an in-law or spouse of the designated beneficiary. As long as the new beneficiary meets one of those designations, there would be no tax consequences to the change.

Amounts contributed to a 529 plan are treated as complete gifts even though the donor retains control over the funds. A donor may also elect to treat contributions to the plan as if the contributions were made over a five-year period to take advantage of the annual gift exclusion of $19,000 ($38,000 if a split gift with spousal consent). Thus, you could front-load a 529 plan in 2026 with $95,000 ($190,000 if a split gift with spousal consent) by making an election on your Gift Tax return for the year.

In the event that you elect the five-year spread and die before the end of that five-year period, a pro-rata portion of the gift would be brought back into your estate. If you want to fund an account with more than the annual exclusion protected amount, you could either use a portion of your lifetime taxable gift exemption or wait until after the initial five-year spread period has expired. 

Most 529 plans accept funds from custodial, or Uniform Transfers to Minors Act (UTMA), accounts. However, any withdrawal from the 529 account must be for the benefit of the minor. Accordingly, the beneficiary of these accounts cannot be changed, and the child will assume ownership of the account upon attaining the age of majority. Because only cash can be contributed to a 529 plan, custodial asset holdings may have to be sold prior to the transfer. This could cause significant tax consequences if appreciated property is held in the UTMA account. For this reason, it may be advantageous to maintain the UTMA account and use non-UTMA dollars to fund the 529 account.

Going forward, the UTMA account could be utilized to pay expenses that would not meet the definition of qualified higher education expenses of the beneficiary.

While a 529 plan could impact a potential financial aid recipient’s eligibility, careful planning can protect it. Because an ESP is treated as a parental asset in terms of expected family contribution toward the beneficiary’s education, only 5.64% or less of the value of the account will be included in the financial aid calculation, as long as the beneficiary is a dependent student. In contrast, 20% of a child’s asset base is counted toward the expected family contribution. Withdrawals from a 529 plan will not impact eligibility for financial aid in the next calendar year. However, withdrawals from 529s owned by grandparents may have to be included as the child’s income for financial aid calculations. This could be lessened by using financial aid in the initial years of school and saving 529 holdings for the later years of a beneficiary’s education. 

An account owner or designated beneficiary can make investment changes within the group of allowable investments up to twice annually. 

As of 2020, Section 529 plans began permitting distributions of up to $10,000 of qualified student loan repayments. An additional $10,000 can be used to pay off qualified student loan repayments for each of the 529 plan beneficiary’s siblings. It’s important to note the $10,000 is a maximum lifetime amount for each individual and not an annual limit. In addition to qualified student loan repayment, the SECURE Act further expands 529’s by providing that qualified higher education expenses include expenses for certain apprenticeship programs. 

As of 2024, you may be able to move some 529 money directly into a Roth IRA if certain conditions are met. The conditions are:

• The Roth IRA receiving the funds must be in the name of the beneficiary of the 529 plan.
• The 529 plan must have been maintained for 15 years or longer.
• Any contributions to the 529 plan within the last five years (and the earnings on those contributions) are ineligible to be moved to a Roth IRA.
• The annual limit for how much can be moved from a 529 plan to a Roth IRA is the IRA contribution limit for the year, less any “regular” traditional IRA or Roth IRA contributions that are made for the year (in other words, no doubling up with funds from outside the 529 plan). 

A Section 529 plan can now be used for postsecondary credentialing expenses incurred on and after July 5, 2025. These expenses include skilled trade and vocational programs, professional license and certification fees, required continuing education, and required materials as part of qualified credentialing or licensing programs.

• Beginning in 2026, the One Big Beautiful Bill Act doubles the annual maximum benefit available for K-12 expenses from $10,000 to $20,000. 

IRC 529 plans offer a tax-effective way to handle the increasing cost of education. The federal income, gift, and estate tax benefits, as well as ongoing donor control and sizable contribution limits with no income limitations, combine to provide a compelling reason to open one. Education funding remains an important financial planning goal, and a 529 plan account is an excellent way to plan for potential tax-free growth.