How does the Secure Act affect 529 plans?

published by:
KENT GROFF, CFP®
July 26, 2021
How does the Secure Act affect 529 plans

How does the Secure Act affect 529 plans?

As back to school season is upon us, let's dive into ways to save for your children's or grandchildren's education and explore ways to utilize state 529 plans. 

We will also cover what constitutes "qualified expenses," recent changes to 529 programs, and changes coming down the road.

529 Plans

As one of the most popular education savings vehicles, 529 plans offer flexibility and potential tax advantages. Contributions to 529 plans are made with after-tax dollars, grow tax-deferred, and withdrawn tax-free for qualified education expenses. While there is no federal tax deduction for 529 plan contributions, 37 states and the District of Columbia offer state-level deductions or credits as a savings incentive.

Note- this chart does not consider everything for Maryland deductibility. For more guidance, refer to our blog post "The Best 529 Plan for Maryland Residents."

For a refresher, here are a few of the main benefits of 529 plans:

  • Tax deferral on investment growth and tax-free distributions if used for qualifying education expenses (including $10k per year in K-12 tuition and $10k in total student loans payments for the beneficiary and each of their siblings)
  • Much higher contribution limits & more flexibility than Coverdell Education Savings Accounts
  • A state income tax education in many states for contributions
  • The ability to change the beneficiary if needed, making 529 plans very flexible for account owners with multiple grandchildren
  • Contributions to 529 plans are a completed gift. At the same time, the owner maintains control, which is a unique opportunity for those concerned with paying estate taxes.
  • Grandparents may contribute up to the gifting limit in a 529 without concern about the generation-skipping transfer tax.
  • The ability to front-load five years' with of gift tax exemptions ($75k)

What Constitutes as a "Qualified Expense"?

529s are specifically for Qualified higher education expenses. That extends beyond tuition; it also includes fees, room & board, textbooks, computers, and "peripheral equipment" (like a printer).  Withdrawals made for purposes outside the rules will hurt: Earnings withdrawn for non-qualified expenses are subject to a 10% penalty and ordinary income taxes. However, there is no tax or penalty on the principal.

There are a few exceptions:

If the beneficiary receives a scholarship, you can withdraw funds equal to the amount awarded. However, while the earnings are subject to taxes, there will be no additional penalty. 

Parents are also free to change the beneficiary on the account at any time. For example, suppose your first child decides to take a different path. In that case, you can change the account beneficiary to a sibling.

TCJA & SECURE act Changes:

  • Tax Cuts & Jobs Act: $10,000  withdrawal for annual tuition expenses of public, private, or religious elementary or secondary school. This annual allowance is per student, not per account.
  • SECURE Act: expanded the definition of qualified higher education expenses to include student loan payments and apprenticeship programs. This Act provides more options for families to use these savings tax-free. These new 529 rules are retroactive for distributions made after December 31, 2018.
  • SECURE Act: Student loan repayment- 529 plan holders can now withdraw any remaining savings to put toward their student loan debt or that of their children, grandchildren, or spouses. The law includes an aggregate lifetime limit of $10,000 in qualified student loan repayments per 529 plan beneficiary and $10,000 for each beneficiary's siblings. Siblings may consist of a brother, sister, stepbrother, or stepsister. For example, a family with two children can take out a maximum of $20,000 to pay down student loans.

Changes coming down the road (2023/2024 Academic year): Removal of the Grandparent trap

One significant change in the pipeline includes how contributions to education are treated by non-parental figures like grandparents. Today, 529 account balances owned by grandparents do not count as an asset on the FAFSA. Still, distributions to pay for education for the beneficiary do count as untaxed student income. Untaxed student income can offset financial aid by 50%, meaning that a $5,000 distribution from a grandparents 529 could reduce aid by $2,500.

This concern about lowering financial aid has been a planning issue for many years. Several workaround strategies have been used to help grandparents support education via a 529 plan. Examples include waiting until the later college years for the grandparent to make a distribution to avoid the income being included in the FAFSA or using the 529 account to pay student loans.

So how will it change in the 2023/2024 school year?

According to SavingforCollege.com, the updated 2023/2024 FAFSA does not require students to report cash support. That means a 529 account opened by a grandparent, aunt, uncle, or family friend and its distributions will not have any impact on need-based financial aid eligibility. With the removal of the "grandparent trap," the 529 plan becomes even more appealing to grandparents interested in contributing to their grandchild's education.

A whole new set of future strategies

The current 529 savings landscape includes several strategies to maximize the advantages while minimizing any adverse effect on financial aid. With distributions from non-parental 529 plans not being counted, would it now make sense for parents to contribute to the grandparents' plan instead? However, be cautious about building new strategies on a rule change that is not yet active. Because this change is a couple of years away, we may see additional guidance on how these rules will be applied.

Have questions about your personal financial situation? Please contact us to discuss.

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