Tax-Preferred College Savings Plans: An
Introduction to 529 Plans
Margot L. Crandall-Hollick
Analyst in Public Finance
November 2, 2012
Congressional Research Service
7-5700
www.crs.gov
R42807
CRS Report for Congress
Pr
epared for Members and Committees of Congress
Tax-Preferred College Savings Plans: An Introduction to 529 Plans
Contents
Introduction ...................................................................................................................................... 1
Overview of 529 Plans ..................................................................................................................... 1
Types of 529 Plans: Prepaid and Savings Plans ............................................................................... 2
Tax Treatment of 529 Plans ............................................................................................................. 5
Income Tax Treatment ............................................................................................................... 6
Contributions ....................................................................................................................... 6
Distributions ........................................................................................................................ 6
Calculating the Taxable Portion of a 529 Distribution: A Stylized Example ...................... 7
Interaction with Other Education Tax Benefits ......................................................................... 8
Rollovers and Transfers ............................................................................................................. 9
Gift Tax .................................................................................................................................... 10
Interaction of Assets and Distributions from 529 Plans with Federal Student Aid ........................ 10
Concluding Remarks ..................................................................................................................... 11
Figures
Figure 1. Calculating the Taxable Portion of a 529 Distribution: A Stylized Example ................... 8
Tables
Table 1. Comparison of 529 Prepaid and Savings Plans.................................................................. 4
Contacts
Author Contact Information........................................................................................................... 12
Congressional Research Service
Tax-Preferred College Savings Plans: An Introduction to 529 Plans
Introduction
In the face of the rising cost of higher education, families may consider a variety of ways to
finance their children’s college expenses. In order to make higher education more affordable,
Congress has enacted legislation that provides favorable tax treatment for college savings. Among
the options families may choose to save for college, they may consider using tax-advantaged
qualified tuition programs (QTPs), also known as 529 plans. This report provides an overview of
the mechanics of 529 plans and examines the specific tax advantages of these plans. For an
overview of all tax benefits for higher education, see CRS Report R41967, Higher Education Tax
Benefits: Brief Overview and Budgetary Effects, by Margot L. Crandall-Hollick.
Overview of 529 Plans
529 plans, named for the section of the tax code which dictates their tax treatment, are tax-
advantaged investment trusts used to pay for higher-education expenses. The specific tax-
advantage of a 529 plan is that distributions (i.e., withdrawals) from this savings plan are tax-free
if they are used to pay for qualified higher education expenses. If some or all of the distribution is
used to pay for nonqualified expenses, then a portion of the distribution is taxable, and may also
be subject to a 10% penalty tax.1 (A description of qualified and nonqualified expenses is
provided later in this report.)
Generally, a contributor, often a parent, establishes an account in a 529 plan for a designated
beneficiary, often their child.2 Upon establishment of a 529 account, an account owner, who
maintains ownership and control of the account, must also be designated. In many cases the
parent who establishes the account for their child also names themself as the account owner.
According to federal law, payments to 529 accounts must be made in cash using after-tax dollars.3
Hence, contributions to 529 plans are not tax-deductible to the contributor. The contributor and
designated beneficiary cannot direct the investments of the account, and the assets in the account
cannot be used as a security for a loan. A contributor can establish multiple accounts in different
states for the same beneficiary.4 Contributors are not limited to how much they can contribute
based on their income. Similarly, beneficiaries are not limited to how much they can receive
based on their income. However, each 529 plan has established an overall lifetime limit on the
amount that can be contributed to an account, with contribution limits ranging from $250,000 to
nearly $400,000 per beneficiary.5,6
1 The tax will be paid by either the beneficiary or the owner of the 529 plan account.
2 The individual who maintains and controls the 529 account may not necessarily be a contributor. For example, a
grandparent (contributor) could establish a 529 account for their grandchild (beneficiary), but have the child’s parents
be the account owners who maintain and control the account.
3 This can include checks, money orders, and credit card payments. Payments cannot be made in the form of securities.
4 For example, an account can be established for beneficiary X in state A’s 529 plan, and an account can be established
for beneficiary X in State B’s 529 plan. These two plans for beneficiary X can be established by the same contributor or
different contributors.
5 The Internal Revenue Code (IRC) § 529 (b)(6) does require that 529 plans limit the amount of contributions to an
account to an amount “necessary to provide for the qualified higher education expenses of the beneficiary.”
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Tax-Preferred College Savings Plans: An Introduction to 529 Plans
Types of 529 Plans: Prepaid and Savings Plans
There are two types of 529 plans: “prepaid” plans and “savings” plans. A 529 prepaid plan allows
a contributor (i.e., a parent, grandparent, or non-relative) to make lump-sum or periodic payments
that entitle the beneficiary to a specified number of academic periods, course units, or a
percentage of tuition costs at current prices. Essentially, the contributor is paying for and
purchasing a given amount of education today which will be used by the student in the future,
providing a hedge against tuition inflation. For example, a contributor could purchase in 2011 two
years of community college education in the Nevada Tuition Prepaid Program for a newborn for
$4,170 (extended payment plans are available).7 Generally, a prepaid plan is used to purchase
education at a public in-state institution.8 Prepaid plans are established and maintained by a state
or a state agency or by an educational institution.9,10 Prepaid plans tend to have certain restrictions
in terms of the expenses they cover, residency requirements, and eligible educational institutions.
In some states, the value of these plans is backed by the full faith and credit of the state
government, implying that the state bears the risk of the account performance, not the account
holder.
A 529 savings plan allows contributors to invest in a portfolio of mutual funds or other underlying
investments.11 Contributors can make periodic investments directly in the plan, with the ultimate
value of these accounts determined by the performance of the underlying investments. In
addition, 529 savings plans can be purchased directly from a plan manager (“direct sold”) or
purchased through financial advisers (“broker sold”). Unlike prepaid plans, the amount of
education which can ultimately be purchased using a savings plan is not guaranteed. Instead the
amount of education that can be purchased depends on both the cost of education and the
performance of the underlying assets in the 529 savings plan. In addition, the value of savings
plans is not limited to tuition at in-state public institutions. Savings plans are established and
maintained by a state or a state agency, but tend to be less risky for the state to administer because
their value is typically not guaranteed by the state.12
(...continued)
6 For more information, see http://www.savingforcollege.com/compare_529_plans/index.php?
plan_question_ids%5B%5D=308&mode=Compare&page=compare_plan_questions&plan_type_id=.
7 This is often referred to as the contract price. Joseph F. Hurley, The Best Way to Save for College: A Complete Guide
to 529 Plans 2011-2012 (Pittsford, NY: JFH Innovative LLC, 2011), p. 250.
8 While all 529 distributions can be used to pay for out-of-state colleges, most prepaid plans provide the greatest
benefits for in-state colleges. If a student who has a 529-prepaid plan chooses to go to either an in-state private
institution or an out-of state public institution, the prepaid benefits will be set at the equivalent level of public in-state
tuitions, with many prepaid plans using a weighted-average credit hour value of in-state public institutions. In addition,
the value of the prepaid benefits for out-of-state and private institutions is limited to the lesser of the value of in-state
tuition and fees or the actual tuition. Hence, if the tuition paid at an out-of state institution is less than in-state tuition,
the student will not receive a refund for the difference.
9 Currently, there is one prepaid program operated by an educational institution—the Private College 529 Plan. See
https://www.privatecollege529.com/OFI529/.
10 States can hire outside vendors like TIAA-CREF, Merrill Lynch, or Fidelity to manage investments and
administrative duties.
11 For example, a portfolio of equities and bonds whose percent composition changes automatically as the beneficiary
ages, a portfolio with fixed shares of equities and bonds, or a portfolio with a guaranteed minimum rate of return.
12 Similar to prepaid plans, states can hire outside vendors to manage investments and handle administrative duties.
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Tax-Preferred College Savings Plans: An Introduction to 529 Plans
While prepaid 529 plans were the first type of 529 plan established, savings plans have grown in
popularity and are now the most common type of 529 plan. There are currently 19 prepaid 529
plans offered in contrast to the over 90 savings plans.13 In addition, according to the most recent
data, of the $164.9 billion worth of assets in 529 plans at the end of 2011, 87.9% ($144.9 billion)
were held in savings plans, while 12.1% ($20.0 billion) were held in prepaid plans.14
There are a variety of differences between savings plans and prepaid plans which may explain the
increased popularity of savings plans. States may be more inclined to offer savings plans because
they may be less costly or risky for states to run. Many states back prepaid plans with their full
faith and credit. In these cases, states must provide a guaranteed benefit to beneficiaries of 529
prepaid plans, even if they do not have sufficient funds in the state’s 529 trust to pay for
beneficiaries’ college expenses. Hence, these plans can be riskier for states to sponsor.15 In fact,
one of the first 529 prepaid plans established, the Michigan Education Trust (MET) had to close
to new beneficiaries shortly after starting because “the program administrators had relied on
overly optimistic projections of the rate of return on invested funds in relation to the trust’s
obligation to pay for rising tuition prices. Simply put, the trust was headed toward insolvency.”16
Savings plans may also be more common because they are more popular with students and their
families. Savings plans generally can be used for more types of expenses at a wider variety of
institutions than prepaid plans, making them attractive to parents who may not know where their
child will ultimately go to college or how much it may cost.17 In addition, prepaid programs
generally require that either the account owner or beneficiary meet state residency requirements,
limiting who can ultimately invest in these plans. The majority of savings programs are open to
contributors and beneficiaries irrespective of their residency.
Notably, while there are many differences between prepaid and savings plans, the tax treatment of
these plans (which will be described later in this report) is identical. Hence, there is not a greater
tax benefit associated with one plan rather than another and contributors may compare other
features of these plans detailed in Table 1Table 1 when deciding which plan is the most
appropriate type for their needs.18
13 Joseph F. Hurley, The Best Way to Save for College: A Complete Guide to 529 Plans 2011-2012 (Pittsford, NY: JFH
Innovative LLC, 2011).
14 These data were provided by the College Savings Plan Network and are available upon request.
15 In spite of the greater popularity of savings plans, prepaid plans tend to be less risk for parents than savings plans.
Unlike 529 savings plans, the purchasing power of prepaid plans is guaranteed. In other words, if you purchase one
semester of education at today’s prices, you will be able to purchase one semester of education when the child attends
college.
16 Joseph F. Hurley, The Best Way to Save for College: A Complete Guide to 529 Plans 2011-2012 (Pittsford, NY: JFH
Innovative LLC, 2011), p. 12. The program later resumed and is again operational after adjusting its pricing.
17 Andrew P. Roth, “Who Benefits from States’ College Savings Plans?” Chronicle of Higher Education, January 1,
2001.
18 Contributors may also look at other attributes of the plans which are specific to each plan, including the fees
associated with each plan, when deciding the most appropriate 529 plan.
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Tax-Preferred College Savings Plans: An Introduction to 529 Plans
Table 1. Comparison of 529 Prepaid and Savings Plans
Prepaid Savings
Number 19
93
Qualified
Generally they cover tuition and required
Qualified distributions can be used for tuition and
Expenses
fees, in most cases at undergraduate
required fees, room and board (capped), books,
institutions.
supplies, equipment, and additional expenses of
special needs beneficiaries.
Residency
Account owner or beneficiary general y has
Account owner or beneficiary general y does not
Requirements
to meet state residency requirements.
have to meet state residency requirements,
although more favorable benefits (state tax
deductibility, matching) may be provided to in-
state residents.
Institutional
In-state public institution (if used out for out
Varies from plan to plan, but generally available
Limitations
of state school, the amount is generally
for a wide variety of public and private
limited to in-state tuition and fees at public
institutions nationally. (Any eligible educational
institution).
institution meeting Federal Title IV
requirements).
Refund
If not al of the amount is used by the
An amount not used can be taken out as a
student, contributors can request a refund,
nonqualified distribution. The amount withdrawn
although the refund amount is determined by as a refund is ultimately determined by plan
the 529 plan.
performance.
Distributions
Directly to institution.
Beneficiary or account owner or directly to
Go To
institution.
Time Limitation
Most prepaid plans can only be used for a
Generally, there is no program imposed limit on
limited duration, generally a given number of
how long the account may remain open (as long
years from the beneficiary’s expected
as the beneficiary is living).
matriculation date.
Enrol ment
Generally yes. Each year, contributors must
No
period
purchase future col ege education during a
given period. Prices are adjusted annual y
before each enrol ment period.
Who Bears
In some states, the plans are backed by the
Contributors bear the risk because the
Risk?
full faith and credit of the state government,
performance of the plan is determined by the
meaning the state bears the risk.
performance of the underlying assets.
Source: Internal Revenue Code (IRC) §529. Internal Revenue Service, Publication 970: Tax Benefits for Education,
2011, http://www.irs.gov/pub/irs-pdf/p970.pdf. Joseph F. Hurley, The Best Way to Save for Col ege: A Complete
Guide to 529 Plans 2011-2012 (Pittsford, NY: JFH Innovative LLC, 2011).
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Tax-Preferred College Savings Plans: An Introduction to 529 Plans
Tax Treatment of 529 Plans
As previously mentioned, the specific tax-advantage of a 529 plan is that the withdrawals from
these plans are excludable from gross income, and hence not subject to the income tax, if they are
used to pay for specific higher education expenses incurred in a given year. These expenses are
referred to as adjusted qualified higher education expenses (AQHEE—see shaded text box
below). Any amount withdrawn from a 529 account which does not go towards these expenses is
subject to income taxation and may be subject to an additional 10% penalty tax.
Logically, a taxpayer who receives a 529
distribution (often the beneficiary or the
Glossary of Selected Terms19
account owner) would seek to minimize their
Account Owner: The person with ownership and
income tax liability by withdrawing just
control of the 529 account. This individual is usual y a
contributor to the account.
enough money from their 529 account to cover
AQHEE and no more. However, this is not as
Basis: The sum of al the cash contributed or paid into
straightforward as it may seem due to a variety
the account.
of factors, including the availability of other
Designated Beneficiary: The individual for whom the
education tax benefits and student aid.20 In
account is established.
order to understand the complex decisions
Distribution: An amount of cash withdrawn from a 529
taxpayers must consider when determining the
account (or in the case of prepaid plans, the value of the
amount of money they should withdraw from a
education benefits paid by the plan.)
529 plan, this section details the income tax
Earnings: The total account value minus the basis.
treatment of 529 distributions, including the
definition of AQHEE; when 529 distributions may be taxable; and the interaction of 529
distributions with other education tax benefits. (An overview of basic gift tax rules is also
included).
Adjusted Qualified Higher Education Expenses
Qualified higher education expenses are expenses related to enrollment or attendance at an eligible educational
institution and include any of the following (or combination thereof):21
•
tuition, fees, books, supplies, and equipment required for enrollment or attendance of the beneficiary at an eligible
educational institution;
•
expenses for special needs services incurred in connection with enrol ment or attendance of a special-needs
beneficiary at an eligible educational institution; and
19 Adapted from Joseph F. Hurley, The Best Way to Save for College: A Complete Guide to 529 Plans 2011-2012
(Pittsford, NY: JFH Innovative LLC, 2011), p. 9.
20 Timing issues may also introduce more complexity. Specifically, education expenses are incurred over an academic
year, which does not correspond with a tax year (tax years are generally calendar years).
21 An eligible education institution for purposes of 529 plans is any college, university, vocational school, or other
postsecondary educational institution eligible to participate in a student aid program administered by the U.S.
Department of Education.
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Tax-Preferred College Savings Plans: An Introduction to 529 Plans
•
room and board expenses for students enrolled at least half-time22 at an eligible educational institution.23
To determine the amount of adjusted qualified higher education expenses, qualified higher education expenses must
be reduced by the amount of any tax-free educational assistance. Tax-free educational assistance includes the tax-free
portion of scholarships and fellowships, veterans’ educational assistance, Pell grants, and employer-provided
educational assistance. They also must be reduced by the value of expenses used to claim education tax credits (see
“Interaction with Other Education Tax Benefits”).
Income Tax Treatment
Contributors to 529 plans receive no federal income tax benefit from funding a 529 plan. Instead
the main beneficiaries (in terms of reduced income taxes) of 529 plans are the recipients of 529
distributions, who may be able to exclude the entire 529 withdrawal from income taxation. In
most cases, the recipient of the 529 distribution (and hence the person who may be liable to pay
tax on the distribution) is either the designated beneficiary or the account owner.24
Contributions
Contributions made to 529 plans are not deductible from income, meaning that contributions to
these plans are made using after-tax dollars. Additionally this implies that contributors to 529
plans receive no federal tax benefit from contributing to a 529 plan. In contrast, many states allow
residents to deduct part or all of their 529 contributions from their state income taxes if they
contribute to an in-state plan. All 529 plan contributions are allowed to grow tax-free in the 529
account. Hence, unlike the typical bank savings account, where interest income is annually
subject to income taxes, the increase in asset values in a 529 plan account is not subject to current
income taxes, while the funds are in the account.
Distributions
Distributions from 529 plans are not subject to federal income taxes if, for a given year, the
withdrawal entirely covers adjusted qualified higher education expenses (AQHEE). In other
words, if the amount of the distribution is less than or equal to the adjusted qualified higher
education expenses (AQHEE), the entire distribution is tax free.
22 A student is considered “enrolled half-time” if he or she is enrolled for at least half the full-time workload for his or
her course of study, as determined by the educational institution’s standards.
23 Room and board expenses cannot be more than the greater of (1) the allowance of room and board that was included
in the cost of attendance for federal financial aid purposes for a particular academic period and living arrangement of
the student or (2) the actual amount of room and board charged if the student resided in housing owned or operated by
the eligible educational institution.
24 In the case of a prepaid 529 plan, the payment goes directly to the institution, instead of the beneficiary or the
account owner.
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If a distribution is used to pay for nonqualified expenses, a portion of the withdrawal, specifically
the earnings portion of the distribution, is subject to the income tax and may be subject to a 10%
penalty tax. In other words, if the amount of a 529 withdrawal is greater than the beneficiary’s
AQHEE, the earnings portion of the
distribution is taxable. The earnings
The Taxable Portion of a 529 Distribution
portion of a distribution reflects the
growth of the value of the 529 plan and
not amounts originally contributed
1 AQHEE (adjusted qualified higher education expenses) are qualified higher
(which are sometimes referred to as
education expenses (QHEE) reduced by any tax free educational assistance
basis). The percentage of the earnings
and by the portion of the expenses used to claim higher education tax credits.
portion subject to taxation is equal to the
ratio of the difference of the total distribution amount and AQHEE to the total distribution
amount (see shaded text box above). To ultimately calculate the amount of tax the taxpayer will
owe, the taxpayer’s marginal tax rate must be applied to this taxable income. In addition, in many
cases, a 10% penalty tax will also be applied to this taxable income.25
Calculating the Taxable Portion of a 529 Distribution: A Stylized Example
Mr. Smith establishes an account in a 529 plan for his daughter Sara in 2007. He is the account
owner and his daughter is the designated beneficiary. He makes a one-time contribution (i.e.,
basis) of $10,000. Five years later the account balance is $15,000 (i.e., it has increased in value
by $5,000) and Mr. Smith takes a $9,000 distribution in 2012 for his daughter’s $9,000 fall 2012
tuition payment. But Sara also receives a $4,000 tax-free scholarship. Hence, Sara has $5,000 in
AQHEE in 2012 ($9,000 of tuition minus $4,000 in tax-free aid). Notably, Mr. Smith pays Sara’s
tuition costs and also designates himself as the recipient of the 529 distribution, implying he (and
not his daughter) will be liable to pay any taxes on the 529 distribution.26
The steps to calculate the taxable portion of the distribution—and it is taxable because adjusted
qualified education expenses ($5,000) are less than the 529 distribution ($9,000)—are outlined in
Figure 1.
First, Mr. Smith must calculate the proportion if the distribution which is earnings. Since one-
third of the account balance ($5,000) reflects earnings (two-thirds of the account balance reflects
$10,000 of contributions), one-third of the distribution is attributable to earnings. Second, Mr.
Smith applies the earnings ratio (in this case, one-third) to the distribution. Hence, of the $9,000
distribution, one-third or $3,000 reflects earnings. Finally, Mr. Smith calculates the proportion of
the $3,000 earnings portion which is subject to taxation. The percentage of the earnings portion
which is subject to taxation is equal to the ratio of the difference of the total distribution amount
25 The 10% penalty tax is waived in the following cases: (1) the distribution is paid to the beneficiary after their death;
(2) the distribution is made because the beneficiary is disabled (the beneficiary is considered disabled if he shows proof
that the he cannot do any substantial gainful activity because of a disability. A physician must determine that the
disability is either life threatening or will have an indefinite duration); (3) the distribution is greater than qualified
education expenses (and hence the earning portion is taxable) because the beneficiary received tax-free educational
assistance as long as distribution is not more than the tax-free assistance; (4) the distribution was made as a result of the
beneficiary’s attendance at a U.S. military academy to the extent that the distribution is not greater than the cost of
attendance at such an academy; (5) the distribution was taxable as a result of reducing qualified expenses in order to
claim higher education tax credits.
26 The account owner of a 529 account selects the recipient of the distribution when filing out the program’s withdrawal
request form.
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Tax-Preferred College Savings Plans: An Introduction to 529 Plans
($9,000) and AQHEE ($5,000) to the total distribution amount ($9,000). Ultimately, as Figure 1
illustrates, of the $9,000 distribution, $1,333 of it is includible in Mr. Smith’s income and thus
subject to taxation on his 2012 income tax return.
Figure 1. Calculating the Taxable Portion of a 529 Distribution: A Stylized Example
Source: Congressional Research Service using information obtained from the Internal Revenue Service,
Publication 970: Tax Benefits for Education, http://www.irs.gov/pub/irs-pdf/p970.pdf and Joseph F. Hurley, The
Best Way to Save for College: A Complete Guide to 529 plans 2011-2012 (Pittsford, NY: JFH Innovative LLC, 2011).
Interaction with Other Education Tax Benefits
In addition to 529 plans, there are a variety of other tax benefits taxpayers (either the beneficiary
or the account owner) may use to lower their income tax bill based on education expenses.27
27 As a result of a temporary provision, from 2002 through 2012, taxpayers can make contributions to both a 529 and
Coverdell for the same beneficiary in the same year. However, beginning in 2013, this temporary provision is
scheduled to expire. Hence, if a taxpayer makes a contribution to both a 529 and Coverdell for the same beneficiary in
the same year, the contribution to the Coverdell will be considered an excess payment and be subject to income
taxation and a penalty tax.
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Notably, taxpayers may be eligible to claim either the American Opportunity tax credit (AOTC),28
the Lifetime Learning credit, or the tuition and fees deduction.29 A taxpayer cannot claim more
than one of these tax benefits for the same student in a given year.
To determine if any of their 529 distribution is taxable, a taxpayer must reduce their 529 qualified
higher education expenses by any amounts used to claim either the AOTC or the Lifetime
Learning credit. The qualified higher education expenses as defined for 529 plans are not
identical to the qualified higher education expenses of education tax credits. The qualified higher
education expenses common to both 529 plans and education tax credits are tuition and fees, and
hence these are the expenses which taxpayers may (mistakenly) try to use to claim both an
education tax credit and a tax-free 529 distribution. (Other expenses, like room and board which
are a qualified expense for 529 plans, are not a qualified expense for education tax credits and
hence would not be used to claim an education tax credit.) For example, if an eligible taxpayer
has $10,000 of tuition payments of which they used $4,000 to qualify for an American
Opportunity tax credit, the amount of qualified higher education expenses used to determine if
their 529 distribution is tax free is $6,000. Thus, if a 529 distribution is less than or equal to
$6,000, none of the distribution is subject to taxation because the distribution covered all of their
AQHEE.
Instead of an education tax credit, a taxpayer may choose to take both a 529 distribution and
claim the tuition and fees deduction for the same student in the same year. Taxpayers who take a
529 distribution and also choose to claim the tuition and fees deduction must reduce the amount
of expenses used for the tuition and fees deduction by the earnings portion of the 529 distribution
(not the entire amount of the distribution).30
Rollovers and Transfers
Any distribution from a 529 plan for a given beneficiary which is rolled over into a different 529
plan for either the same beneficiary31 or a member of the beneficiary’s family32 is not taxable. A
distribution is considered “rolled over” if it is paid to another 529 plan within 60 days of the
distribution. Importantly, a rollover between 529 plans for the same beneficiary is limited to once
28 For more information on the AOTC, see CRS Report R42561, The American Opportunity Tax Credit: Overview,
Analysis, and Policy Options, by Margot L. Crandall-Hollick.
29 Under current law, the tuition and fees deduction expired at the end of 2011. Hence, barring any legislative changes,
taxpayers will be ineligible from claiming this above-the-line deduction on their 2012 tax returns.
30 The Internal Revenue Code (IRC) and IRS Publication 970 provide different explanations on how to coordinate 529
distributions and the tuition and fees deduction for a given student. Since IRS Publication 970 does not have the force
of law, the literal interpretation of the IRC is described in this report. According to IRC § 222(c)(2)(B), the total
amount of qualified tuition and related expenses used to claim the tuition and fees deduction must be reduced by the
earnings portion of a 529 distribution used for the same expenses. In contrast, according to Publication 970, a taxpayer
reduces the amount of AQHEE used to calculate the taxable portion of a 529 distribution by the amount of tuition and
fees used to claim the tuition and fees deduction. In some cases, the tax savings of these two different approaches may
differ.
31 Only one rollover from one 529 plan to a different 529 plan for the same beneficiary is allowed in a 12-month period.
32 For the purposes of a 529 plan, the beneficiary’s family includes the following: the beneficiary’s son, daughter,
stepchild, foster child, adopted child (or decedent of any of these children); brother, sister, stepbrother, stepsister;
father, mother, or their ancestors; son or daughter of a brother or sister; brother or sister of father or mother; son-in-law,
daughter-in-law, father-in-law, mother-in-law, brother-in-law, or sister-in-law; the spouse of any of the individuals
previously listed (including the beneficiary’s spouse); and first cousin.
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every 12 months. In addition, if the designated beneficiary of an account is changed to a member
of the beneficiary’s family, the transfer of funds is not taxable.
Gift Tax
A contribution to a 529 plan is generally not subject to the gift tax if the amount contributed is
less than the annual gift tax exclusion.33 For 2012, the annual gift tax exclusion is $13,000.34 For
example, a grandparent could contribute $13,000 to each of their seven children’s 529 accounts
without being subject to the gift tax.35 In addition, a contributor may be able to deposit more than
the annual exclusion amount into a 529 plan without being subject to the gift tax.36 The Internal
Revenue Code (IRC) allows a donor to make a contribution larger than the annual gift tax
exclusion by treating the contribution as if it were made ratably over five years. In other words, a
contributor could open a 529 savings plan for a beneficiary in 2012 and contribute up to $65,000
(five times $13,000) without being subject to the gift tax. The contributor could not make another
excludable gift to that beneficiary’s 529 plan until 2017. In addition to these gift tax rules, for the
purposes of the estate tax, a donor can exclude the value of the 529 plan from their gross estate,
even though they maintain control of the account.
Interaction of Assets and Distributions from 529
Plans with Federal Student Aid37
In addition to the tax advantages of 529 plans, these plans are also treated more favorably than
other types of college savings or investments when determining a student’s eligibility for federal
need-based student aid. For instance, 529 plans generally have a minimal impact on a student’s
federal expected family contribution (EFC). The EFC is the amount that, according to the federal
need analysis methodology, can be contributed by a student and the student’s family toward the
student’s cost of education. All else being equal, the higher a student’s EFC, the lower the amount
of federal student need-based aid he or she will receive. A variety of financial resources are
reported by students and their families on the Free Application for Federal Student Aid (FAFSA).
These resources are assessed at differing rates under the federal need analysis methodology 38
Distributions39 from 529 plans are generally not considered income in the federal need analysis
calculation and are therefore not reported on the FAFSA, although the value40 of the 529 plan is
33 Contributions to 529 plans treated as a completed gift which implies the transfer of ownership from the contributor to
the beneficiary, even though contributors to Section 529 plans maintain control of the accounts.
34 $26,000 for a married couple using gift-splitting.
35 Each grandparent could contribute $13,000 each, meaning they could deposit $26,000 per grandchild as a couple
without being subject to the gift tax.
36 For an overview of the current law of the gift tax, see CRS Report 95-416, Federal Estate, Gift, and Generation-
Skipping Taxes: A Description of Current Law, by John R. Luckey.
37 For further description of federal need analysis, see CRS Report R42446, Federal Pell Grant Program of the Higher
Education Act: How the Program Works, Recent Legislative Changes, and Current Issues, by Shannon M. Mahan.
38 The details of the federal need analysis methodology are beyond the scope of this report.
39 Additionally, distributions from 529 plans are not considered a resource when calculating other estimated financial
assistance (EFA) during the federal aid packaging process. For more information on EFA and the packaging of aid, see
the AY2012-13 Federal Student Aid Handbook, Volume 3, at http://ifap.ed.gov/fsahandbook/1213FSAHbVol3.html.
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Tax-Preferred College Savings Plans: An Introduction to 529 Plans
considered an asset in the federal need analysis methodology and should be reported on the
FAFSA.41
When calculating a student’s EFC, the federal need analysis methodology considers a percentage
of the student’s assets and a percentage of the parents’ assets reported on the FAFSA. A student’s
assets are assessed at a flat rate of 20%, while parents’ assets are assessed on a sliding scale,
resulting in a maximum effective rate of up to 5.64%.42 Therefore, the ownership of the asset is
important when determining how it will affect a student’s EFC. For students who are classified as
dependent students for FAFSA purposes (which differs from the classification of dependent for
tax purposes),43 the 529 plans are considered an asset of the parent, as long as the custodial
ownership of the plan belongs either to the parent or student. Therefore, dependent students
benefit from a lower assessment rate on 529 plans, which, all else being equal, results in a lower
EFC and the potential for more federal need-based student aid. For students who are classified as
independent students for FAFSA purposes, 529 plans are treated as an asset of the student, as long
as the custodial ownership of the plan belongs either to the student or student’s spouse (if
applicable). 529 plans that are owned by someone other than the student, parent, or spouse are not
reported as an asset on the FAFSA, but distributions from these 529 plans are reported as untaxed
income for the beneficiary on the FAFSA.44 In general, income is assessed at a higher rate
compared to assets in the federal need analysis methodology.
Concluding Remarks
Students and their families may have a variety of resources to choose from when they finance
higher education expenses, including 529 plans. While these plans may encourage some families
to save for and fund their child’s future education expenses, they may also introduce additional
complexity in financial planning. For example, parents may start contributing to a 529 plan when
their child is very young, based on their predictions of future college costs that they may not
ultimately pay because their child receives a scholarship, or another education tax benefit or
federal financial aid. This would result in the parent over-contributing to a 529 plan, when those
contributions could have been used for other purposes, like their retirement accounts. Hence,
while these plans may be beneficial to students, benefits should also be weighed against potential
drawbacks.
(...continued)
40 For 529 plans that are considered pre-paid tuition plans, the asset value is equal to the refund value.
41 For prepaid 529 plans, the asset value is the refund value of the plan.
42 Parental assets are also protected by an asset protection allowance, which means that a certain amount of assets are
not considered in evaluating the effective family contribution (EFC).
43 For the purposes of taxes, IRC §152 defines dependents which includes (but is not limited to) a requirement that the
dependent has the same principal residence as the taxpayer for more than half the year, and that the dependent has not
provided over one-half of their support. In contrast, student under 24 are generally considered a dependent for financial
aid purposes. If certain criteria are met, the student is considered an independent student for financial aid purposes. A
student can determine their dependency status for financial aid at http://www.finaid.org/calculators/dependency.phtml.
44 For more information, see http://www.finaid.org/savings/loophole.phtml.
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Author Contact Information
Margot L. Crandall-Hollick
Analyst in Public Finance
mcrandallhollick@crs.loc.gov, 7-7582
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