Feb 05, 2022
Higher education isn't inexpensive. Therefore, you should start saving for it while your child is still learning their ABCs, rather than cramming for the SATs.
College savings vehicles such as 529 plans are popular because they provide several attractive benefits to those who participate. They do, however, come with a slew of restrictions.
Investing in a 529 plan is tax-free as long as the money is used to pay for eligible higher education expenditures. In some jurisdictions, parents who open a 529 account when their children are young might benefit from tax savings, compounding returns, and the ability to deduct contributions from their state's taxes.
Since we've already discussed, you'll be subject to federal income tax as well as a 10% penalty on the taxable part of any withdrawals made from a 529 plan to pay for non-qualified costs. A portion of your payment will be based on your initial contributions, while the rest will be based on profits.
Flexible, tax-deferred school savings accounts, known as 529 savings plans, can be used to save for college. You can use a 529 plan to pay for eligible education expenditures at the elementary, middle, and high school levels, as well as for college and beyond.
Funds from a 529 plan may be used to cover the entire cost of a full-time undergraduate or graduate education at a recognized school, including tuition, fees, books, supplies, allowed study equipment, and housing and board.
Many families are concerned that saving for college may jeopardize their prospects of securing financial assistance. However, because 529 savings plans are considered the property of the parents, only a maximum of 5.6% of its value is taken into account when calculating federal financial assistance.
As a result, only up to 5.6 percent of 529 assets are included in the federal financial assistance process's estimated family contribution (EFC). Compared to the possible 20 percent tax rate that may be imposed on student assets, such as those in a custodial account, this is a far lower tax rate. Find out how the EFC is computed.
Compared to other college savings programmers, a 529 plan has fewer limits. There are no limits on these plans in terms of income or age, and the annual contribution cap usually is about $300,000 in most cases (varies by state).
Contributions to the Coverdell ESA are capped at $2,000 per year, and only those with an adjusted gross income of $110,000 or less for single filers, or $220,000 or less for married couples filing jointly, are eligible to participate. A 529 savings plan can be opened and funded by anybody, including students, parents, grandparents, and other family members.
Because the account owner (and not the kid) controls the money, a 529 savings plan is more flexible than a custodial account, which eventually passes ownership to the child. The account owner can transfer the funds to another beneficiary (e.g., a family member of the original beneficiary) for any reason, preventing the kid from spending the money on something other than college.
An account owner can transfer money to another beneficiary if the original kid for whom the account was set up does not go to college or spend all of the capital.
The 10% penalty on taxable income may or may not be applied depending on the circumstances. Among these is a distribution when the recipient passes away, becomes incapacitated, or enters a military academy in the US.
It is also waived if the family is required under the American Opportunity Tax Credit (AOTC) or Lifetime Learning Credit (LLC) to pay income tax on the part of their 529 withdrawal (LLC). If your kid receives other forms of financial aid for their schooling, you may be exempt from this rule as well. In the next part, we'll discuss the scholarship exemption. 3
Tax-free college scholarships and grants can be reduced from your kid's overall qualified education expenditures so you can calculate their adjusted eligible education expenses (AQEE). On the other hand, the scholarship exemption permits penalty-free withdrawals up to the amount of the scholarship.
That portion of the payout will still be subject to income tax. Thus, the profits will be taxed. You can avoid taxes and penalties if you use the money to pay for eligible educational expenditures.
Since Section 529 was added to Public Law 104-188 in 1996, tax experts have been debating the timing of a 529 plan distribution depending on a scholarship.
Some experts believe there is no time limit for distributing funds, while others think you must do so before your child graduates or the money must be withdrawn in the same calendar (tax) year in which it was received.
Neither Congress nor the IRS provides clear guidance on this issue, resulting in various opinions. Rachel Murley, an enrolled agent with RKM Accounting and Tax LLC, has a more conservative approach. When it comes to dealing with the IRS, "like most things with the IRS, you have to read between the lines," she explains.