College? Grad school? Private school? Not sure yet? No problem! The assets in your 529 plan can be used in a variety of ways. Education can deliver a number of long-term benefits, both personally and professionally. A 529 plan is a tax-advantaged investment vehicle designed to save for the education expenses of a beneficiary. These plans offer several benefits that can help make the most of the money you invest for college.
529 plans take their name from the section of the Internal Revenue Code that was enacted by Congress when the plans were created in 1996. 529 plans are officially known as Qualified Tuition Plans, a tax-advantaged investment vehicle designed to help families pay for future education expenses. There are two types of 529 plans: savings plans and prepaid tuition plans. Both are generally sponsored by states or state agencies. Forty-nine states and the District of Columbia sponsor one or more 529 plans.
What is a 529 Plan?
Prior to the adoption of the Federal Tax Cuts and Jobs Act of 2017, 529 plans were principally designed to fund college and other higher education expenses. With the adoption of the new law, 529 plan assets are now available to fund elementary or secondary public, private or religious school expenses. However, federal taxfree qualified withdrawals from 529 plans for these expenses are capped at $10,000 per year per student. While such withdrawals will have no federal tax impact; individual state tax treatment of K-12 withdrawals varies.
Additionally, the Setting Every Community Up for Retirement Enhancement Act of 2019 expanded the benefits of 529 education savings plans by including certain student loan repayments, up to $10,000 per beneficiary, and the cost of certain apprenticeship programs as qualified higher education expenses.
We encourage account owners to consult with a qualified tax advisor about their personal situation prior to making such withdrawals as they may be subject to adverse state tax consequences.
In general, most U.S. citizens or permanent residents are eligible to set up a 529 plan for any beneficiary, including themselves. Each plan has its own eligibility requirements, so please consult your Financial Advisor or the plan offering documents for more information. The tax advantages, investment options, restrictions and fees can vary a great deal. Understanding the differences between plan types and state-specific state tax benefits is important. Morgan Stanley Financial Advisors do not provide tax or legal advice and so we encourage you to consult your individual tax or legal advisor.
How Can I Purchase a 529 Plan?
Most states offer more than one 529 plan. Some states offer both advisor-sold and direct-sold savings plans while other states only offer direct-sold savings plans. 529 plans can be effective within a comprehensive financial plan. With that potential, however, comes a significant amount of complexity that looks across an investor’s finances and investment holdings.
What Types of 529 Plans Are Available?
529 plans are generally managed by investment management firms, (e.g., mutual fund companies) and your contributions are generally invested in underlying investment options such as ETFs that support the plan. Your investment will fluctuate in value, so there is no guarantee that the amount contributed to the plan will equal the amount necessary for future education expenses. Savings plans may offer greater flexibility than prepaid tuition plans because they offer multiple investment options, and you are not restricted to using the account balances for a specific educational institution (or group of institutions) or within the sponsoring state.
You may also be able to apply the proceeds from a savings plan to other expenses (e.g., room and board, textbooks, supplies and equipment) in addition to tuition and fees. Many states offer more than one savings plan, providing residents with a choice of investment management firms.
What Are the Federal Tax Considerations?
529 plans offer significant tax advantages for education saving investors. Earnings grow tax-deferred and withdrawals from a 529 savings plan are not subject to federal income tax if utilized for qualified education expenses at an eligible educational institution. The term “qualified education expenses” generally includes tuition, required fees, books, supplies, certain required equipment, and the cost of room and board (subject to certain limits). An “eligible educational institution” generally includes most community colleges, public and private four- year colleges, universities, graduate and postgraduate programs, certain vocational schools that are eligible to participate in federal student financial aid programs, and the elementary and secondary schools described above.
If you make a withdrawal for purposes other than to pay your beneficiary’s qualified education expenses, then the earnings portion of the withdrawal is subject to federal and possibly state income tax and an additional 10% federal tax penalty. Distributions, whether taxable or not, are reported to the IRS the year in which they are taken. This will be reported on IRS Tax Form 1099-Q. Once positions are liquidated, cash balances are no longer part of the 529 Plan.
What State and Local Tax Benefits Apply?
You and/or your beneficiary’s state of residence may affect your ability to qualify for any applicable state and local tax benefits granted to 529 plan investments. Many states provide tax incentives and other benefits for state residents who invest in a plan sponsored by their home state, which may include:
- State tax deductions for contributions
- Deferral of state income taxes on earnings maintained in the plan
- State income tax-free qualified withdrawals
- Matching grants or scholarships
Additionally, so-called “in-state plans” often waive or rebate certain fees and expenses for state residents. The benefits of purchasing an in-state plan generally apply only if you or your beneficiary live or pay state income taxes in the 529 plan sponsor’s state. If you invest in a 529 plan sponsored by a different state than where you live or pay state income taxes, typically, you will not receive the any state tax or other benefits provided to residents. In addition, your state or locality may seek to recover the value of any previously taken state or local tax benefits if you roll over or transfer account assets from an in-state plan to another state’s 529 plan.
Before investing in a 529 plan, you should consider whether the state(s) where you or your beneficiary reside or pay state income taxes sponsor an in-state plan and whether the tax and other benefits afforded to state residents are significant to you based on your particular circumstances. Depending on the state where you live or pay state income tax, your contribution amount and tax status, the tax savings from the state income tax credit or deduction may be up to $1,000 or more per year. In certain states, these benefits may be the most significant factor for you in choosing a plan. Your Morgan Stanley Financial Advisor can direct you to information about in-state plans and select out-of-state 529 plans and the availability of state or local income tax or other benefits offered. Other factors to consider include the variety of investment options available, including the range of investment objectives and strategies offered, risk factors related to the variety of investment options or the lack of variety, relative performance, fees, and services.
Where is My Money Invested?
Your contribution to a 529 savings plan is invested in a portfolio(s), generally consisting of underlying mutual funds. Although very similar to mutual funds in design and structure, a 529 savings plan’s portfolios are issued by state governments, and in most cases, are not directly regulated under the federal securities laws applicable to mutual funds, but rather the Municipal Securities Rule making Board. Most savings plans offer the following types of investment options:
- Static Investment Portfolios – Your contributions will be invested in a portfolio that does not change, remaining “static” over time in a specific combination of underlying mutual funds. The specific underlying mutual funds are combined to achieve a specific risk/ reward relationship. You should speak with your Financial Advisor to determine if a static portfolio is appropriate for you.
- “Age-Based” or “Years-to-Enrollment” Investment Options – Your contributions will be invested in a portfolio that will automatically change over time depending on the age of your beneficiary or the number of years left before your beneficiary enrolls in an educational institution (also known as the date of matriculation). The investment manager adjusts the allocation of specific underlying mutual funds and their relative weighting within the portfolio over time, generally growing more conservative over time.
- Individual-Fund Investment Options – Your contributions will be invested entirely in one or more portfolio(s) each consisting of a single underlying mutual fund and, like static (multi-fund) portfolios discussed above, will not change unless directed by you.
What Fees and Charges Apply with 529 Plans?
529 savings plans’ fees and charges are used by the 529 plan sponsor to support the plan and compensate firms for selling interests in the plan. Some of the fees are based on the amount of assets in your plan account. Other fees are assessed on a transactional or periodic basis. Please see the applicable 529 Plan Program Disclosure for more information on fees and expenses. Total fees, expenses and compensation vary by plan and by plan portfolio.
- State Administration Fees – To help pay for the operation of the plan, some state sponsors of 529 savings plans charge a state administration fee assessed as a percentage of portfolio assets.
- Annual Maintenance Fees/Enrollment Fees/Termination Fees – These fees are generally imposed as a specific dollar amount and apply at specified times or upon certain events (e.g., initial purchase, termination or on the account anniversary).
- Underlying Mutual Fund Expenses – Each investment portfolio indirectly bears a proportional share of the fees and expenses incurred by the underlying mutual fund(s) (e.g., investment management fees and other expenses).
What Restrictions are Placed on 529 Plan Investing?
Your ability to contribute to a 529 plan is not limited by your household income. However, each state limits the total amount of contributions made on behalf of a particular beneficiary. The purpose is to prevent contributions on behalf of a particular beneficiary in excess of the amount necessary to provide for his or her qualified education expenses. The contribution limits on 529 savings plans vary by plan but are generally quite high.
Federal gift taxes may also influence 529 plan contributions. In general, for 2022, cumulative gifts of more than $16,000 to a single person in a single year may be subject to the federal gift tax. A special federal tax law permits individuals to aggregate five years of the allowable $17,000 annual gift tax exclusion and contribute up to $85,000 ($170,000 per married couple) to an account for a designated beneficiary in one year without triggering the gift tax. This assumes that there are no gifts made by the gift giver to the beneficiary in the prior five years. Any gifts made in the five years prior to or the four years after an accelerated gift is made may result in a taxable event. Various conditions and filing requirements apply. You should consult with a tax advisor for more information on the potential tax ramifications of 529 plan contributions and investments.
