What is the use of a 529 plan and its tax implications?

I am not a tax attorney and this is an article for those that are drawn to the Alabama Gazette; not scholarly enough for my peers but based on my research and personal experience. I enjoy the many fine writers that contribute to this paper, but I do not count myself as one of those writers that draw Alabama Gazette readers back month after month. Regardless, I hope that you as a kind reader will gain something from this.

The 529 plan is named after the Internal Revenue Code section in which this plan is derived (26 U.S. Code §529). Each state has a sponsored 529 plan, other type college savings or a prepaid tuition plan; the Alabama 529 plan is administered by Union Bank and Trust. There are almost 126, 000 529 accounts open in Alabama, understanding that there may be multiple accounts open for one child by parents plus grandparents or other relatives. My research shows that only about 35% of families use a 529 type vehicle or other non-standard savings plan for their kids higher education. The contribution is Alabama tax deductible. Though the plan contributions have already been taxed and provided that the funds are only used for educational purposes, then presumably the plan’s appreciable income and dividends typically taxed for individuals are not taxed by the Federal government.

The 529 plan can be used to pay for tuition, books, other educational fees and housing provided the housing is associated with the institution. One would need to communicate with the institution to make sure the room and board is an eligible 529 expense.

Two months after my son was born I began to contribute to a 529 set up by our financial advisor. At a time when I should have been contributing a larger amount I started with a smaller amount not really considering the growth potential over time. On a whole your earlier contributions have an opportunity to grow by a larger percent rather than those contributions made a decade or more later. Union Bank has several investment strategy tiers based on your child’s age and while I am not familiar with the details, I assume that the latter tiers take on more conservative approaches. After all, the investments are directed in the same manner as a prudent individual would invest and there is not only a good historical chance for real growth but understand that the 529 may also be affected by a bear or declining market. Certainly, one thing to avoid if possible is beginning to take withdrawals during a downturn in the economy.

While I have named several higher education costs that a 529 can be used for, there are many other circumstances in which a 529 can be used, some based on changes in the law such as the Secure Act of 2022. In addition to using 529 money for higher education, you can also use up to $10,000.00 per year for K-12 schools. Such schools may be private, charter or public, but one would need to check with the school or your advisor on the specifics.

You cannot tax deduct in Alabama more than what is capped which is $10,000.00 per year per set of married parents who file married and jointly on their taxes. Otherwise the tax deductible contributions are capped at $5,000 per person.

When a child is very small, it is difficult to have any idea about your child’s future educational needs. Will it only be a technical school, or will they do so well that scholarship money covers the majority of educational expenses? What if the child died? What if the child does not pursue higher education? The answers are as follows. The 529 can be transferred to a family member for educational use. One can withdraw up to $10,000 to pay towards an educational loan. If the money is in the account for a minimum of fifteen years and the money is unneeded then the maximum contribution for a Roth IRA of $7,000 per year currently can be placed in a Roth IRA provided that the beneficiary’s name exists both on the 529 and the Roth IRA. This can be done year after year until a maximum of $35,000.00 has been rolled over. Imagine your smart kid that gets a lot of college paid for by scholarship and if as much as $35,000 exists it can be rolled over to a Roth IRA at a maximum rate of $7,000.00 per year. As an example, a 529 is opened and funding begins after birth. After contributing for fifteen years and say the child is a 10th grader with all A’s. Should you strongly feel or know to some degree that the child should have significant scholarships available then you may thereafter set up a Roth, contributing $7,000 per year for the next five years. In that scenario a Roth IRA such as this can grow significantly for retirement after a contribution of $35,000.00 has been made and the child has only just graduated a four year college. Looking forward to age 67 with no further contributions and a 6% average return could yield an amount approaching a half of a million dollars.

It's difficult to know the best answer for your child’s educational funding while also funding for your golden years. You must use your best judgement and talk to professionals. A simple savings account will never yield the kind of returns a 529 has the potential for and you pay taxes on dividends. A high yield savings account can come closer to the yields of a 529 but again you have to pay taxes on dividends. Alabama has a functioning PACT plan which prepaid tuition but was closed years ago to new participants after significant financial woes. Even a child that does very well in their earlier years may as a teen take a less than enthusiastic approach to high school, ruining your plans of full scholarships. But your goof off kid that barely makes it through high school may get it together in college and become a very successful architect as did a child of one of my good friends.

This article is informative only and not meant to be all inclusive. Additionally this article does not serve as legal advice to the reader and does not constitute an attorney- client relationship. The reader should seek counsel from their attorney should any questions exist.

"No representation is made that the quality of legal services performed is greater than the quality of legal services performed by other lawyers."

THE VIEWS OF SUBMITTED EDITORIALS MAY NOT BE THE EXPRESS VIEWS OF THE ALABAMA GAZETTE.