First, What is a 529 College Savings Plan? 

A 529 plan is a state-sponsored investment account that allows families to save for education-related expenses, including tuition, books, and certain room and board costs. The funds can be used for K-12 education, postsecondary education (college, trade schools, etc.), and in some cases, student loan repayment or apprenticeship programs. 

529 plans come in two forms: 

1. Prepaid Tuition Plans: These allow you to lock in today’s tuition rates for future education. 
2. Education Savings Plans: These work like traditional investment accounts, allowing you to invest in mutual funds or ETFs. While your money is in the account, any investment earnings are tax-free, assuming the funds are used for qualified education expenses. For the sake of this talk, we are going to focus on this variety. Before we dive in, it’s important to understand that each state maintains its own 529 plan program. So, while 529 plans are offered by custodians like Charles Schwab and Fidelity, in order to harness the tax benefits, in most cases you must own the state’s 529 plan where you reside. Here in New York, that can be done by opening an account on NYSaves.org. 

Taxation of 529 Plans 

One of the most appealing aspects of 529 plans is their tax advantages. Here’s a breakdown of how they’re taxed: 

• Contributions: Contributions to a 529 plan are made with after-tax dollars, meaning you don’t get a federal tax deduction. However, many states offer tax deductions or credits for contributions made to in-state plans. These deductions or credits vary by state, so it’s worth researching your home state’s offerings to maximize potential savings. As of 2024, here in New York, if you are married and filing jointly and are the owner of a 529 plan, you can deduct up to $10,000 as an above line deduction on your New York state income taxes for your contributions. For example, if you are married and give $12,000 to a 529 plan of which you are the owner, you can deduct 10,000 of that contribution as an above line deduction on your New York state taxes. 
  
• Next let’s talk about earnings: While your money is in the account, no taxes will be due on any investment earnings or growth that may be generated. 

• Finally let’s touch on withdrawals: As long as the funds are used for qualified education expenses (tuition, room and board, books, fees, etc.), the withdrawals are tax-free at the federal level and, in most cases, at the state level. If the money is used for non-qualified expenses, it is subject to income tax on the earnings portion, plus a 10% federal penalty. Some states may impose additional penalties. 

Changing Beneficiaries: How and When 

One of the unique features of a 529 plan is the ability to change beneficiaries. The beneficiary is the person for whom the education savings are intended, but life circumstances—such as the original beneficiary not needing all of the funds or pursuing a non-college path—can change. Fortunately, 529 plans allow flexibility in switching beneficiaries. 

Here’s how it works: 

• Eligible Family Members: The IRS allows 529 plan funds to be transferred to any member of the beneficiary’s family without triggering taxes or penalties. Eligible family members include siblings, parents, aunts, uncles, cousins, or even the original account holder themselves. 
• How to Change Beneficiaries: The process for changing a 529 plan beneficiary is fairly simple and can often be done online or by submitting a beneficiary change form. The key is to ensure that the new beneficiary is a family member, as defined by the IRS, to avoid triggering taxes and penalties. 
• How Often You Can Change Beneficiaries: There is no limit to how often you can change the beneficiary on a 529 plan, but excessive changes might signal to tax authorities that the plan is being misused for tax avoidance. However, as long as the changes are reasonable and follow the IRS rules, you should not face any tax consequences. 
• Beneficiary Strategy Tip: If one child in the family receives scholarships, you can shift funds to another child who may need more assistance or even save the funds for future generations. 

Taxation on Withdrawals 

Withdrawals from a 529 plan can be classified into two categories—qualified withdrawals and non-qualified withdrawals. Understanding how these withdrawals are taxed is crucial for maximizing the value of your plan. 

Qualified Withdrawals 

• Tax-Free Withdrawals: As long as the money is used for qualified education expenses, such as tuition, mandatory fees, textbooks, and room and board (for students attending at least half-time), the withdrawal is not subject to federal income tax or penalties. 
• K-12 Education: Since the passage of the Tax Cuts and Jobs Act (TCJA) in 2017, families can withdraw up to $10,000 per year from a 529 plan to pay for K-12 tuition without incurring federal taxes. However, state tax treatment of K-12 withdrawals may vary, so check with your state’s tax laws. 
• Keep the expenses segregated by calendar year. When using a 529 plan, you must withdraw funds and pay for qualified education expenses in the same calendar year they occur, 

• payments into the following year without potential tax implications and penalties; it’s based on the calendar year, not the academic year. This differs from things like Health Savings accounts where you can maintain receipts forever and pay them off from the HSA years later. 
• Student Loan Payments: Under the SECURE Act, up to $10,000 of a 529 plan can be used to pay for a beneficiary’s student loans. 

Non-Qualified Withdrawals 

• Income Taxes on Earnings: If funds are withdrawn for non-qualified expenses, the earnings portion of the withdrawal will be subject to federal income tax at the beneficiary’s rate. This can sometimes be beneficial if the beneficiary is in a lower tax bracket. 
• 10% Penalty: In addition to income taxes on earnings, non-qualified withdrawals are also hit with a 10% federal penalty on the earnings portion. Some states may impose an additional penalty or require repayment of any state tax deductions previously taken. 
• Scholarship Exception: If the beneficiary receives a scholarship, you can withdraw up to the amount of the scholarship without paying the 10% penalty, although you’ll still owe federal income tax on the earnings portion of the withdrawal. 
• Who pays the tax? If you take a non-qualified distribution from a 529 plan, whose tax rate applies? The recipient of the non-qualified distribution pays the taxes on the distribution. For example, if a parent takes a non-qualified distribution from the 529 plan to pay for travel costs, the parent will pay the taxes if the check from the 529 plan is in the parent’s name. Distributions from a 529 plan may be paid directly to the educational institution, to the beneficiary or to the account owner. Either the account owner or the beneficiary will have to pay income tax on the earnings portion of a non-qualified distribution plus a 10% tax penalty. The person responsible for reporting the non-qualified distribution on their income tax returns depends on the recipient of the taxable distribution 

Key Strategies for Maximizing a 529 Plan 

A 529 plan is more than just a savings account—it’s a powerful financial tool when used strategically. Here are some strategies to consider when managing your 529 plan: 

1. Start Early: The sooner you start contributing to a 529 plan, the more time your investments have to potentially grow. Compound interest can have a significant impact over time, especially if you start when your child is young (source: https://www.schwab.com/learn/story/power-long-term-compound-interest-investments). 
2. Take Advantage of State Tax Benefits: If your state offers a tax deduction or credit for contributions, consider maximizing your contributions each year to take full advantage of these benefits. Be sure to verify that your state’s rules on deductibility align with your savings goals. However, in many states, like New York, you are required to be the owner of the account to take the deduction. So, if you are a grandparent and you have been sending money to your kid’s 529 plan for the benefit of your grandchild, take the 5 minutes to open up your own account so you can take the deduction for yourself! 
3. Gift Contributions: Grandparents and other family members can also contribute to a 529 plan. In fact, under federal gift tax laws, individuals can contribute up to $18,000 (as of 2024) per year per beneficiary without triggering the gift tax. As of 2024, there’s also a special provision allowing five years’ worth of contributions (up to $90,000 per person, per beneficiary) to be made in a single year without incurring gift taxes or having to file a gift tax return. In 2025, these limits will likely increase to $19,000 per person or $95,000 for the super funding method. 
4. Rebalance Your Investments: As your child approaches college age, consider shifting the 529 plan’s investments to more conservative options to help preserve the funds. Many 529 plans offer age-based portfolios that automatically adjust to become more conservative as the beneficiary nears college. 
5. Use 529 Plans for Continuing Education: If the account holder decides to go back to school, they can use their own 529 plan to fund their education. This is especially helpful for career changes or pursuing advanced degrees later in life. 
6. Save for Graduate School: If your child completes their undergraduate education without using all of the 529 funds, the remaining money can be saved for graduate school or transferred to another family member. 

What happens if my kid doesn’t go to college or we have funds left over in the 529 plan? 

Beginning in January of 2024, a new 529 benefit went into effect. This new tax-free distribution will allow any unused 529 funds, subject to certain requirements, to roll over to a Roth IRA for the same 529 beneficiary without incurring any penalty on the earnings. This way, you can use their higher education savings to give them a big jump-start on their retirement savings. 

There are specific requirements in order to use this new qualified 529 distribution. First, a 529 account must be open for the beneficiary for 15 years. Second, the Roth IRA must be for the same beneficiary of the 529. Third, your contributions—also known as the principal—must have been in your 529 account for at least five years before the Roth IRA rollover. Fourth, you can only roll over 529 funds up to the yearly Roth IRA contribution limit, which is $7,000 for 2024. Fifth, the lifetime maximum 529 amount allowed for the Roth IRA rollover is $35,000. Sixth, 529 funds must be converted by paying the amount directly to a Roth IRA—you can’t pay yourself and then deposit the money into the Roth IRA later. Seventh, you can contribute to a Roth IRA only if you have earnings from a job, so the 529 beneficiary must have eligible earnings when the 529-to-IRA conversions occur. And finally, Roth IRA income limits do not apply to 529 rollovers. 

One last push back we hear…is this going to hurt my ability to get federal student aid? 

Previously, distributions from a grandparent’s 529 plan were reported as untaxed student income, which could reduce aid eligibility by up to 50% of the amount of the distribution — a significant penalty. For example, under the old rules, a $10,000 529 plan distribution could reduce your grandchild’s aid eligibility by $5,000. 

However, with the new streamlined FAFSA (started with the 2024–25 award year) there’s now a difference in how distributions are treated compared to previous years, giving grandparents a positive advantage. 

On the 2024-25 FAFSA, students are no longer required to report cash gifts from a grandparent or contributions from a grandparent-owned 529 savings plan. Because of this, grandparents can now use a 529 plan to fund a grandchild’s education without impacting their financial aid eligibility. 

In fact, with the new FAFSA form, a student’s total income is only based on data from federal income tax returns via the IRS. Therefore, any cash support, no matter the source, will not negatively impact financial aid eligibility on the FAFSA. However, at over 200 private institutions that use the CSS Profile for awarding their own financial aid, grandparent-held 529 plans will still be considered. 

Conclusion 

529 college savings plans are a versatile, tax-advantaged way to save for education.

With tax-free growth and withdrawals for qualified expenses, along with the ability to change beneficiaries, 529 plans offer flexibility and control for families preparing for future education costs. However, it’s important to remember that these plans are subject to investment and market risk, account values can fluctuate based on market performance, potentially impacting the funds available when needed. Understanding how these plans are taxed and employing smart strategies can help you maximize the potential of your 529 plan, ensuring that education expenses are covered with minimal financial stress. By starting early and making the most of available tax benefits, you can set up a strong financial foundation for your child or grandchild’s future educational endeavors. 

Disclosures This content is for informational purposes only and does not constitute tax, legal, or investment advice. Consult with your financial, tax, or legal advisor regarding your specific situation before making decisions about a 529 plan or any other investment product. Investments in a 529 plan are subject to market risk, including the possible loss of principal. The value of your investment may fluctuate based on market conditions, and there is no guarantee that the investment objectives will be met. Past performance is not indicative of future results. The tax benefits associated with 529 plans depend on meeting specific requirements under federal and state laws. Consult with a tax professional to understand how these benefits apply to your individual situation. State tax treatment may vary, and it’s essential to review your state’s tax rules and regulations. Adviser is not licensed to provide and does not provide legal, tax or accounting advice to clients. Advice of qualified accountant should be sought to address any specific situation requiring assistance from such licensed individuals.