Congress enacted Section 529 of the Internal Revenue Code to provide individuals with a tax-favored vehicle to save for college expenses. Section 529 plans are sponsored by states and allow an individual to contribute regardless of their income level. The earnings grow tax-free, and withdrawals are now exempt from federal income taxation to the extent they are used to pay qualified higher education expenses (e.g., tuition, books, room and board).
Section 529 plans come in two formats: prepaid tuition plans and variable savings plans. Prepaid tuition plans allow a contributor to purchase tuition units at today’s rates for use in the future. Variable savings plans allow contributors to select among traditional investment options, such as equity mutual funds.
These plans vary from state to state. Generally, however, there are no restrictions as to who can contribute to a Section 529 plan and who can be a beneficiary. An aunt or uncle can establish and contribute to a Section 529 plan for a niece or nephew in the same way parents would establish and contribute to a Section 529 plan for their child. Beneficiaries may have multiple Section 529 plans set up for their benefit. However, there are per beneficiary account limits that vary by state. These limits generally range from $100,000 to $250,000.
Federal gift tax rules apply to contributions made to Section 529 plans. However, there is a special exception in the gift tax rules that allows you to spread a gift to a Section 529 plan over a five year period. You could make a contribution in an amount up to $55,000 ($110,000 for joint gifts with your spouse) in one year, treat the gift as though it was made over a five year period, and not use any of your unified credit or incur gift tax. Be aware, however, that you are precluded from making non-taxable gifts to the beneficiary during that five-year period. Any additional gifts to the beneficiary during this time frame would either utilize a portion of your unified credit or trigger gift tax.
The contributor to a Section 529 plan is deemed the account owner, and therefore has the right to control distributions, change beneficiaries and name successor account owners. If distributions are made for expenses other than qualified higher education expenses, the income associated with the distribution is included in the gross income of the beneficiary and subject to a ten percent penalty tax. The exceptions to this rule are distributions because of a beneficiary’s death, disability or receipt of a scholarship.
Section 529 plans can be started through most major mutual fund companies. Often, you do not need to be resident of or attend college in a particular state to participate in that state’s Section 529 plan. This is not true in all cases however, so use caution when selecting a plan.
— Walter Reed