The purpose of this Memorandum is to provide an overview of the rules governing 529 Education Savings Plans, also known as “Qualified Tuition Plans.” Governed by §529 of the Internal Revenue Code (the “Code”), a 529 savings plan allows a person to establish an investment account (a “529 Account”) for each of an unlimited number of beneficiaries to provide for his or her future qualified higher education expenses, and to a lesser extent, elementary and secondary school tuition. There are no income limitations restricting who may contribute to a 529 Account, and neither the statute nor the regulations require that the beneficiary even be advised of the existence of such an account.
529 Accounts provide the following tax advantages:
- 529 Accounts are tax-exempt and, thus, realize pre-tax growth;
- Qualifying contributions within the annual gift exclusion amount are free of the gift tax and the generation-skipping transfer tax;
- Qualifying distributions for educational expenses are income-tax-free to the designated beneficiary;
- The value of such accounts will not be includible in your gross estate even though you, as account owner, retain control over any 529 Accounts that you establish; and
- You can deduct up to $5,000 per year for contributions made by you to New York 529 Accounts in computing New York taxable income.
I. Contributions to 529 Plans
- Contributions within the Annual Exclusion Amount
Although contributions to a 529 Account are to be used for future education expenses of the beneficiary, Code Section 529 treats such contributions as a gift of a “present interest” and not of a “future interest”. Therefore, a contribution to a 529 Account on behalf of a designated beneficiary is treated as a completed gift to which the annual exclusion applies. Thus, you can contribute up to $15,000 each year to each 529 Account that you establish utilizing your annual exclusion available for each beneficiary (provided that you make no additional gifts to that beneficiary in the same year).
- “Frontloading” the Annual Exclusion
Code §529 provides for an election to treat transfers made to a 529 Account in a single year as made ratably over a 5-year period. In other words, you can front load a 529 Account with up to five times the annual gift tax exclusion amount without incurring gift tax or utilizing any of your federal gift tax exemption. The annual gift exclusion amount is currently $15,000; accordingly, you can fund a 529 Account with $75,000 ($15,000 x 5) in one calendar year, and, provided that you make the election, the gift will be treated as being made ratably over the year in which the contribution was made and the next four years. The election is made on a federal gift tax return, Form 709, which is filed for the year of the initial contribution. If you do not make any other gifts that would require you to file a Form 709 in any of the next 4 years after the election, you do not need to file Form 709 to report that year’s portion of the election amount.
You do not have an option to allocate a front-loaded contribution over less than five years. If the amount of your contribution in the first year exceeds the annual exclusion amount, but is less than five times such amount, and you make the election, that amount is nevertheless allocated over five years. For example, if you contribute $45,000 in year 1 and make the election, you will be treated as making a $9,000 gift for each of 5 years and not a $15,000 gift for each of 3 years.
- Contributions in Excess of the Annual Exclusion Amount
Any amount contributed in excess of the annual exclusion amount, or five times the annual exclusion amount if you elect to front-load, is treated as a taxable gift in the calendar year of contribution and will reduce your available federal gift exemption. The exemption is currently $11,580,000 for 2020, and is scheduled to revert to $5,000,000 (indexed for inflation) on January 1, 2026.
II. Distributions from 529 Plans
The federal income tax treatment of a distribution from a 529 Account depends upon whether the distribution is either a qualified distribution or a nonqualified distribution.
- Qualified Distributions for Higher Education Expenses
If you use 529 Account withdrawals for qualified higher education expenses, the earnings are not subject to federal income tax. The following is a list of qualified expenses for a designated beneficiary enrolled at an eligible postsecondary school:
- Tuition and fees;
- Books, supplies, and equipment;
- Expenses for special needs services needed by a special needs beneficiary must be incurred in connection with enrollment or attendance at an eligible postsecondary school;
- Expenses for room and board incurred by students who are enrolled at least half-time;
- The purchase of computer or peripheral equipment, computer software, or Internet access and related services if it is to be used primarily by the beneficiary during any of the years the beneficiary is enrolled at an eligible postsecondary school;
- Expenses for fees, books, supplies, and equipment required for the designated beneficiary’s participation in certain apprenticeship programs; and
- No more than $10,000 paid as principal or interest on qualified student loans of the designated beneficiary or the designated beneficiary’s sibling. A sibling includes a brother, sister, stepbrother, or stepsister for this purpose.
- Qualified Distributions for Elementary and Secondary Schools
In addition to payments for higher education expenses set forth paragraph “a” above, funds in 529 Accounts can also be used to pay up to $10,000 per year for the beneficiary’s tuition at any public, private or religious elementary or secondary school.
- Taxable Distributions
529 Account distributions that are used for anything other than qualified higher education expenses or tuition for elementary or secondary schools (up to $10,000/year) will be subject to state and federal income taxes. Income tax will be imposed on the earnings portion (not the entire distribution) at the recipient’s tax rate. To quantify the earnings portion, both the contribution amounts and the earnings amounts must be tracked for the duration of the 529 Account. The earnings portion is taxed as ordinary income, without regard to the portion of the earnings attributable to capital gain income.
In addition to the income tax, a 10% federal tax penalty will be imposed on the earnings portion of a nonqualified distribution.
III. Changing the Beneficiary of a 529 Plan
A further feature of 529 Accounts is that you can change the beneficiary of the account if the named beneficiary does not need to use his or her entire account balance or does not go to college, or for any reason. No adverse federal tax consequences will result from a change in beneficiary if: (i) the new designated beneficiary is a member of the family of the prior designated beneficiary; and (2) for gift and generation-skipping transfer tax purposes, the new designated beneficiary is not assigned to a generation lower than that of the previous designated beneficiary.
 “Member of the family” is defined under Code §529(e)(2) to include a person related to the beneficiary as a: (1) son or daughter (or the descendant of either); (2) stepson or stepdaughter; (3) son-in-law or daughter-in-law; (4) father or mother (or the ancestor of either); (5) stepfather or stepmother; (6) mother-in-law or father-in-law; (7) brother, sister, stepbrother, or stepsister; (8) child of a brother or sister (but not of a stepbrother or stepsister); (9) brother or sister (but not stepbrother or stepsister) of the father or mother; (10) first cousin; (11) spouse; (12) brother-in-law or sister-in-law; or (13) spouse of any individual described above. Thus, “member of the family” includes a beneficiary’s nephews and nieces and their spouses, but excludes their children (grandnephews and grandnieces). It also excludes a spouse’s nephews and nieces, the ancestors of stepparents or parents in law, and descendants of stepchildren or children in law.